The penalties for breach of contract are a sanction often chosen to prevent and punish breaches of contract of parties. However, it is necessary for the parties to pay attention to avoid the circumstances where such penalties may not be enforceable or not be effective. Hereinafter 4 remarkable contents when including the penalty clause in a contract.
1. Conditions for applying penalty clauses
Pursuant to Clause 1, Article 418 of the 2015 Civil Code and Article 300 of the 2005 Commercial Law, a penalty clause may only be applied when the parties have reached an agreement on penalties for breach of contract. Therefore, if the parties do not agree on the penalty clause in the contract, there is no basis for the aggrieved party to request the breaching party to pay a fine.
Additionally, the aggrieved party has the obligation to prove that the other party has breached his/her/its obligation under the contract to request the fine. Pursuant to Clause 1, Article 351 of the 2015 Civil Code, breach of an obligation means that the obligor fails to perform an obligation on time, incompletely performs an obligation, or improperly performs an obligation. At the same time, only if the breach does not fall into either case of exemption from liability for breaches prescribed in Clause 2, Article 351 of the 2015 Civil Code or Article 294 of the 2005 Commercial Law, may the aggrieved party apply the sanction of penalty for breach of contract.
In addition, if the contract is invalid, the penalty clause shall not become valid. Because an invalid civil transaction shall not give rise to, change or terminate any civil rights and obligations of the parties from the time of establishment of such transaction – Pursuant to
Clause 1, Article 131 of the 2015 Civil Code. And the parties shall not be bound by the obligations defined in the contract, including the penalty clause.
2. Penalty level
Pursuant to Clause 2, Article 418 of the 2015 Civil Code, the penalty level shall be agreed upon by the parties, unless otherwise prescribed by relevant law. The parties to a contract must, therefore, consider the nature of the transaction and the regulating law to determine the appropriate penalty level.
Specifically, in the field of commerce, the penalty level for a breach shall be agreed upon by the parties but must not exceed 8% of the value of the breached contractual obligation portion. In the field of construction, for works using public investment funds or state capital other than public investment funds, the penalty level must not exceed 12% of the value of the violated contract part.
But there is no law regulation on the handling cases where the parties apply a penalty level exceeding the maximum penalty level specified by law. Normally, only the payment request for the penalty amount equaling the statutory ceiling penalty level or fewer is accepted by the tribunal. For this reason, the penalty level for breach defined in the contract should be carefully considered and calculated to ensure the effectiveness of the penalty clause.
3. Determination of the value of breached contractual obligation portion
In the fields of commerce and construction, the penalty level for a breach shall be agreed upon by the parties but must not exceed the ceiling one that is calculated according to the value of the breached contractual obligation portion. However, there is no law regulation on determination of value of the breached contractual obligation portion. If the parties cannot determine the value of breached obligation portion on their own, the tribunal has no basis to accept the request for the penalty amount to be paid.
In practice, there are non-monetary obligations that are not normally the primary obligation of the contract but are related to the labor, such as those of advertising, marketing, etc. Thus, the parties should include specific provisions on the value of such obligations to serve as a basis for applying the penalty level for breach in the contract or keep papers related to expenses for performance of the above-mentioned obligations when drafting and negotiating the penalty clause.
4. Simultaneous application of sanctions of penalty for breach of contract and compensation for damage
There is a significant difference in the simultaneous application of sanctions of penalty for breach of contract and compensation for damage between civil relations and commercial
relations. Pursuant to Article 418 of the 2015 Civil Code, in case the parties have an agreement on payment of penalties for breach of contract but have no agreement on payment of both penalties and compensation for damage, the breaching party shall only be liable to pay penalties.
In the field of commerce, according to the 2005 Commercial Law, in case the parties have an agreement on payment of penalties for a breach of contract but have no agreement on payment of compensation for damage, the aggrieved party shall be entitled to request the payment of both penalties and compensation for damage from the breaching party.
In conclusion, for the penalty clause in a contract, it is very important to determine whether the legal relation in the such contract is a civil relation or commercial relation. Such determination of legal relation in contracts affects not only the determination of the penalty level, but also the simultaneous application of the penalty of breach of contract and another sanction.
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