To Penalise or to Punish: Penalties and Punitive Damages Under South Korean Law

The validity of penalty clauses, as compared to liquidated damages, is generally recognised in civil law jurisdictions – and South Korea is no exception. This stance taken by civil law jurisdictions is also widely understood by lawyers practising in common law countries. However, the framework and application of penalties in South Korea possess unique characteristics that distinguish South Korean-style penalties from similar concepts in other civil law countries, such as Germany or France.

On the other hand, South Korean law does not recognise punitive damages in tort. However, there has been a noticeable shift, with an increasing number of individual legislations specifying punitive damages in South Korea.

Before delving into the topic of penalties under South Korean law, it is necessary to clarify the terminology. Under South Korean law, the legal term corresponding to (contractual) penalty is “wiyakbeol”, which translates literally to “penalty for breach of contract”. However, this specific term does not appear in the Civil Code of the Republic of Korea (South Korea) (the “South Korean Civil Code”), despite being acknowledged through judicial interpretation by the South Korean courts. Although the South Korean Civil Code explicitly employs the term “liquidated damages” or “the amount of damages determined in advance” (Article 398(2)), it does not refer to the Korean term corresponding to contractual penalty. Instead, the term “wiyakgeum” – literally translating to “money for breach of contract” – appears in South Korean Civil Code (Article 398(4)) and encapsulates the notion of both liquidated damages and penalties. It is noteworthy that the translation provided by the Ministry of Government Legislation translates wiyakgeum as penalty (Article 398(4)), potentially leading to confusion among foreign practitioners.

According to the South Korean courts, the purpose of penalty is to ensure the fulfilment of obligations, whereas liquidated damages are to specify in advance the amount of compensation that a debtor is required to pay in the event of non-performance. The liquidated damages mitigate challenges associated with proving the extent of damages. The roles of liquidated damages and penalties are fundamentally distinct (Korean Supreme Court Judgment No 2018da248855, 2018da248862, dated 21 July 2022).

This principle is similarly articulated in the landmark case of Dunlop. Here, the court held that “the essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage” (Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd (1914) UKHL 1).

Penalties are considered a form of private sanction within the realm of contract law. While South Korean laws prohibit punitive damages in tort, they permit penalties within contractual relationships between parties. Interestingly, in the USA – a common law country – punitive damages are allowed under tort law, but contractual penalties are not recognised as valid.

South Korean law clearly distinguishes penalties from liquidated damages – a distinction that sets it apart even from civil legal systems such as those of Germany or France. South Korean courts maintain that penalties are separate from compensation of damages; therefore, if a contract includes a penalty clause, it can be enforced alongside and in addition to claims for actual damages due to non-performance (Korean Supreme Court Judgment No 2018da248855, 248862, dated 21 July 2022).

In principle, penalties cannot be reduced by the courts, whereas liquidated damages are subject to reduction as explicitly provided by the South Korean Civil Code (Article 398(2)). According to the South Korean Civil Code, an amount specified to be paid in the event of breach is deemed to be liquidated damages (Article 398(4)). That is, if there is ambiguity regarding whether a specified amount is intended as a penalty or as liquidated damages, it will be presumed to be liquidated damages and thus becomes subject to reduction by the courts.

South Korean courts demonstrate a significant degree of flexibility when reducing liquidated damages in construction contracts, taking the various circumstances into account. By way of example, in certain situations, the South Korean courts have reduced the contractual liquidated damages by approximately 30% after acknowledging that a contractor faced challenges in proving that delays were caused by COVID-19 even though it was probable that the contractor encountered difficulties under such exceptional circumstances.

It is important to note that not all amounts specified to be paid in the event of a breach will automatically be classified as liquidated damages. Such classification will be determined by considering the contract as a whole and taking into account the parties’ intentions.

Under South Korean law, a penalty is valid and non-reducible, reflecting the courts’ emphasis on the sanctity of agreements between parties. This marks a critical difference from the concept of liquidated damages under South Korean law. However, this position varies across civil law jurisdictions. By way of example, under German law, contractual penalties (Vertragsstrafe) deemed “disproportionate or excessively high” are subject to reduction.

Even though South Korean law generally upholds the validity and non-reducibility of penalties, exceptions exist where penalties can be invalidated in full or in part. This is not based on the specific provision of the South Korean Civil Code allowing reduction but, rather, on public policy considerations as set out in the law (Article 103 of the South Korean Civil Code).

South Korean courts have determined that a penalty stipulated in an agreement, if imposing an excessive burden on the debtor beyond the creditor’s interest, may be wholly or partially nullified for violating public morals and social order. However, in interpreting penalty agreements, it is critical to exercise caution so as to avoid undermining the parties’ autonomy in the name of public policy. South Korean courts underline the necessity of considering the context in which the contract was formed and its specific provisions (Korean Supreme Court Judgment No 2010da56654, dated 26 December 2013; Korean Supreme Court Judgment No 2013da63257, dated 23 December 2010).

Ultimately, penalties can be invalidated under South Korean law as in common law jurisdictions if they are deemed excessively high. Interestingly, this stance shares commonalities with the approach in the USA, as articulated in Section 356(1) of the Second Restatement of Contracts, which states: “A term fixing unreasonably large liquidated damages is unenforceable on grounds of public policy as a penalty.”

Moreover, the approach of South Korean courts to assess the burden on the debtor against the creditor’s interest bears some resemblance to the evolution demonstrated in the Cavendish case in the UK, where a shift has been made from a strict genuine pre-estimate test towards a principle of legitimate interest. The Cavendish case determined that “the true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation…” (Cavendish Square Holding BV v Talal El Makdessi (2015) UKSC 67).

Under South Korean law, contractual penalties are allowed, whereas punitive damages are generally not recognised in tort unless there are specific South Korean statutes stipulating the punitive damages in the corresponding area. This stance differs from that of the USA, where punitive damages are widely accepted but contractual penalties are not allowed.

The fundamental principle of compensation damages under South Korean law is to restore the victim or affected parties to the state they were in before the damage occurred (Korean Supreme Court Judgment No 2001da58528, dated 5 September 2003). This foundational principle has also influenced the criteria for recognising and enforcing foreign judgments in South Korea. To ensure clarity and prevent any breach of this principle, a specific clause was incorporated into the existing public policy requirements during the revision of the South Korean Civil Procedure Act in 2014. In addition to the general requirements outlined in Article 217 for the recognition of foreign judgments, Article 217-2 was introduced.

In 2011, the Act on Fair Transactions in Subcontracting marked a significant shift by introducing the possibility of awarding treble damages that exceed the scope of the actual damages for harm caused by the unjust actions of principal contractors (Article 35). This approach was expanded upon by the Monopoly Regulation and Fair Trade Act, which established regulations for exemplary damages up to three times the actual damages for unfair collective actions by business owners. This initiative was furthered through the introduction of punitive damages in various legislations, allowing for compensable damages to exceed the actual damages by three to five times for specific actions in areas such as personal information, labour relations, IP rights, and consumer protection.

The provision of punitive damages exceeding the actual damages in specific laws is designed to deter unlawful acts and provide substantial compensation to victims for the injuries they have incurred in certain areas from policy consideration.

South Korean courts also echoed the trend in recent judgments. In 2022, the Supreme Court approved a decision by a court in the State of Hawaii, which ordered triple damages for an act deemed as unfair trade practices – stating that such a decision “cannot be seen as utterly unacceptable in light of the principles, purpose and structure of the compensation system in Korea” (Korean Supreme Court Judgment No 2018da231550, dated 11 March 2022).

For share purchase agreements, construction contracts, or any agreements governed by South Korean law, as well as in scenarios where enforcement within South Korea is anticipated, it is imperative to meticulously evaluate the previously discussed legal nuances and developments. This thorough consideration is crucial not only in the drafting phase of contracts but also in the strategic planning of a potential litigation.