How to Set Liquidated Damages in Contracts in South Korea? Complete Guide | Atlas Legal

1. What are liquidated damages and why are they necessary?

Legal Concept of Liquidated Damages

Liquidated damages are compensation paid by a debtor to a creditor when contractual obligations are not fulfilled within the agreed timeframe. Article 398 of the Korean Civil Act provides that “damages for nonperformance shall be limited to ordinary damages,” while allowing parties to predetermine the amount of damages. This is called ‘liquidated damages,’ which represents predetermined compensation for delay in performance.

Why Liquidated Damages Clauses Are Essential

There are three main reasons why liquidated damages clauses are essential in practice. First, they solve the difficulty of proving damages. Under the Civil Act, to claim damages, the creditor must prove the occurrence and amount of damages. In reality, it is very difficult to accurately calculate and prove damages caused by contract delays. Second, they prevent disputes. Since the amount of damages payable in case of delay is clear, debtors become more careful about performing on time, and creditors can receive compensation without the burden of separate proof, reducing disputes. Third, they enhance contract predictability. Both parties can predict the costs that will arise in case of delay at the time of contract execution, facilitating risk management.

Atlas Legal’s Practical Experience

Atlas Legal has reconfirmed the importance of liquidated damages clauses while reviewing contracts for companies in the Songdo International Business District. One manufacturing company had no liquidated damages clause in their equipment supply contract and, despite a 6-month delay, could not receive even 1 KRW in compensation because they could not prove actual damages. In contrast, another company with an appropriate liquidated damages clause in a contract of the same amount received compensation immediately without any dispute. Based on this experience, Atlas Legal strongly recommends including liquidated damages clauses in all contracts.

2. How are liquidated damages calculated?

Liquidated Damages Calculation Formula

Liquidated damages are calculated using the following simple formula:

Looking at each element of this formula, the contract amount refers to the total agreed price, and whether VAT is included depends on the contract. Days of delay are calculated from the day after the agreed performance date to the actual performance date, including both days. The liquidated damages rate is agreed upon by the parties and is generally expressed on a daily basis.

Specific Calculation Example

Let’s use the e-commerce platform development contract mentioned earlier as an example. If the contract amount is 10 million KRW and the liquidated damages rate is set at 0.075% (the standard under the Act on Contracts to Which the State is a Party), the calculation for a 15-day delay is as follows:

If the delay period is 100 days, the liquidated damages become 750,000 KRW (10,000,000 KRW × 100 days × 0.075%), and if 400 days, they become 3,000,000 KRW. As the delay period lengthens, liquidated damages increase exponentially, which further highlights the importance of setting a cap.

Calculation Precautions

Common disputes in practice regarding liquidated damages calculation involve whether VAT is included and the starting point. Atlas Legal recommends clearly stating in contracts whether “the contract amount includes VAT” or “VAT is separate,” and clearly specifying the starting point for liquidated damages as “from the day following the performance date.” Whether to include holidays and weekends should also be specified to prevent disputes. Generally, the principle is to calculate based on calendar days including holidays and weekends.

3. What standards should be used to set liquidated damages rates?

Liquidated Damages Rate Standards under the Act on Contracts to Which the State is a Party

While liquidated damages rates can be freely determined by the parties, when an objective and reasonable standard is needed, it is common to use the standards from Article 75 of the Enforcement Rules of the Act on Contracts to Which the State is a Party (hereinafter ‘State Contracts Act’). These standards have been applied in public contracts for a long time and are recognized for their fairness and reasonableness, making them widely used in private contracts as well.

Rationale for Differentiated Rates

The reason the State Contracts Act differentiates liquidated damages rates by contract type is that the nature of contracts and the magnitude of damages from delays differ. The Supreme Court of Korea’s judgment (2001Da53059, December 11, 2001) stated that “liquidated damages are predetermined compensation for ordinary damages arising from delay in performance,” recognizing that the magnitude of ordinary damages may differ depending on the nature of the contract. For construction, which generally takes a long time and where partial delays have limited impact on the overall project, the rate is relatively low. For services or repairs, which are scheduled for short-term completion and have greater impact when delayed, the liquidated damages rate is set higher.

Atlas Legal’s Negotiation Strategy

Atlas Legal actively utilizes State Contracts Act standards during contract review and negotiation. Most contracting parties recognize the fairness of these standards and reach agreement without much objection. However, adjustments may be necessary considering the specifics of the contract. For example, for projects with very high uncertainty like new technology development, we lower the liquidated damages rate while more clearly setting the cap. For urgent projects, we raise the liquidated damages rate but specifically enumerate force majeure exemptions to maintain balance. Atlas Legal recently negotiated an R&D contract between a Songdo bio company and a research institution, reaching agreement at 0.08% (lower than the State Contracts Act standard of 0.125%) with a cap of 20%, providing both parties with satisfactory terms.

4. Why should we set a cap on liquidated damages?

Problems That Can Arise Without a Cap

Without a liquidated damages cap, theoretically liquidated damages can increase indefinitely. As seen in the earlier case, with a 0.3% rate and a 400-day delay, liquidated damages on a 100 million KRW contract reach 120 million KRW, creating the unreasonable situation where the debtor must pay money to the creditor even after fulfilling the contract. The Supreme Court of Korea’s judgment (91Da33858, April 28, 1992) stated that “when liquidated damages are unreasonably excessive, the court may reduce them,” but this remedy is only available through litigation. Considering litigation costs and time, setting a cap in advance is much more efficient.

Cap Standards under the State Contracts Act

Article 74 of the Enforcement Decree of the Act on Contracts to Which the State is a Party sets the liquidated damages cap at 30% of the contract amount. This standard is widely accepted in private contracts as well, and Atlas Legal has confirmed that most reviewed contracts follow this standard. The 30% cap is evaluated as a balance point that provides debtors with a predictable maximum loss while ensuring creditors receive substantial compensation.

Considerations When Setting Caps

While 30% is typical, adjustments may be necessary depending on contract characteristics. Atlas Legal recommends cap adjustments in the following cases. First, when contract performance critically affects the creditor’s business (e.g., e-commerce site development with a fixed opening date), the cap can be raised to 40-50%. Second, when technical uncertainty is very high (e.g., new technology development), lowering the cap to 20% or less is reasonable. Third, for very large contract amounts, consider setting the cap as an absolute amount rather than a percentage. For example, for a 1 billion KRW contract, if 30% equals 300 million KRW and this seems excessive, it can be set as “liquidated damages shall not exceed 100 million KRW.” Atlas Legal recently set a cap of 600 million KRW (20%) for a 3 billion KRW large-scale logistics center construction contract in Songdo, Incheon, reaching agreement between both parties.

5. What is the difference between penalties and liquidated damages?

Concept and Characteristics of Liquidated Damages

Article 398(2) of the Korean Civil Act provides that “even when the amount of damages has been predetermined, if the court deems such amount to be unreasonably excessive, it may reduce the amount.” If liquidated damages are specified in a contract but there is no separate designation as a “penalty,” they are presumed to be liquidated damages under the law. The Supreme Court of Korea’s judgment (2012Da13637, August 22, 2013) stated that “presuming them to be liquidated damages is the principle.” The key characteristic of liquidated damages is that courts can review their excessiveness and reduce them. When actual damages and the agreed liquidated damages amount are compared and found to be significantly imbalanced, courts can reduce them ex officio or based on the debtor’s claim.

Concept and Characteristics of Penalties

On the other hand, penalties exclude the application of Article 398(2) of the Civil Act, and courts cannot reduce them. The Supreme Court of Korea’s judgment (93Da24223, November 9, 1993) clearly stated that “when parties have agreed to a penalty, the reduction provision of Article 398(2) of the Civil Act does not apply.” To be recognized as a penalty, the contract must include explicit language such as “this provision shall be a penalty” or “has the nature of a penalty.” The simple title “liquidated damages” is not recognized as a penalty; the parties’ intent must be clearly expressed.

Selection Strategy in Practice

From the client’s (creditor’s) perspective, penalty agreements are advantageous. Without the possibility of court reduction, liquidated damages can be received with certainty, providing strong performance pressure on the debtor. Atlas Legal recommends penalty agreements when project success is critically dependent on delivery deadlines (e.g., online shopping malls that must open for a specific season, facilities that must be completed by a scheduled event date). However, the liquidated damages rate and cap must be set at reasonable levels to obtain the counterparty’s consent. From the contractor’s (debtor’s) perspective, liquidated damages are advantageous because they have room to request court reduction in case of unexpectedly long delays. The Supreme Court of Korea’s judgment (2001Da46216, August 23, 2002) significantly reduced liquidated damages in a case where actual damages were only about 30% of the liquidated damages. Atlas Legal advises contractors to avoid penalty agreements for projects with high technical uncertainty or heavily dependent on external factors, instead using liquidated damages with a clearly set cap. Atlas Legal recently mediated a system development contract between a Songdo AI startup and a financial institution, where the client wanted a penalty but the contractor insisted on liquidated damages, creating a standoff. We reached a compromise by using liquidated damages with a higher rate (0.15%) but a lower cap (20%). This case provided sufficient compensation to the client while offering extreme risk avoidance to the contractor.

6. How should liquidated damages be applied by industry?

IT and Software Development

IT projects can fall under ‘services’ or ‘manufacturing’ according to the State Contracts Act. Simple website creation or customization of existing software is typically classified as ‘services’ (0.125%), while developing new software is classified as ‘manufacturing’ (0.075%). While reviewing contracts for numerous IT companies in Songdo, Atlas Legal has confirmed that most apply 0.075% with a 30% cap. The characteristics of IT projects are high technical complexity and the possibility of requirement changes. Therefore, Atlas Legal recommends including the following clauses. First, an automatic schedule extension clause for requirement changes: “When additional work arises due to the client’s requirement changes, the parties shall negotiate and adjust the schedule, calculating liquidated damages based on the adjusted schedule.” Second, stage-by-stage inspection clause: “Complete inspection at each stage before proceeding to the next stage, and delays in inspection shall not be deemed the contractor’s fault.” Third, force majeure exemption clause: “Delays due to natural disasters, war, infectious diseases, insufficient client-provided materials, or third-party service failures shall be excluded from liquidated damages calculation.”

Construction

Construction projects typically apply 0.05%. Construction generally takes a long time and is heavily influenced by external factors such as weather, permits, and material supply, which is why a relatively low liquidated damages rate is applied. The Supreme Court of Korea’s judgment (2012Da86895, May 14, 2015) stated that “in construction contracts, delays due to force majeure circumstances such as natural disasters or delays in administrative actions by competent authorities are frequent, so reasonable liquidated damages rates considering these should be applied.” When reviewing construction contracts, Atlas Legal always checks the following. First, schedule extension clause based on weather conditions: “When work is impossible due to continuous rain for 3 days or more, or extreme cold or heat, the schedule shall be automatically extended by the corresponding number of days.” Second, permit delay exemption clause: “If permits the client agreed to obtain are delayed, that period shall be excluded from days of delay.” Third, schedule adjustment clause for design changes: “When additional construction arises due to the client’s design change requests, the parties shall negotiate and adjust the schedule.” Atlas Legal recently experienced a case where a small construction company in Songdo nearly bore the full liquidated damages when construction was delayed 6 months due to repeated client design changes, but there was no provision for this in the contract. Through our legal review applying Article 400 of the Civil Act (comparative negligence), we obtained a 70% reduction in liquidated damages.

Manufacturing

Manufacturing applies 0.075%. Contracts to manufacture and deliver machinery, equipment, parts, etc. fall under this category. The characteristic of manufacturing is being affected by raw material supply conditions and subcontractor delivery schedules. When reviewing manufacturing contracts, Atlas Legal recommends the following. First, raw material procurement delay exemption clause: “When raw material procurement is delayed due to circumstances beyond the contractor’s control such as natural disasters, war, strikes, or raw material production cessation, that period shall be excluded from days of delay.” Second, client inspection delay exemption clause: “When the contractor completes the product and requests inspection but inspection is delayed due to the client’s circumstances, the inspection request date shall be deemed the delivery date.” Third, linking with staged advance payment clause: “When the client’s advance payment is delayed, the delivery date shall be automatically extended by the corresponding period” to encourage the client to also comply with agreements.

Services and Consulting

Services and consulting typically apply 0.125%. This includes not only repair, processing, and rental of goods, but also knowledge-based services such as legal, accounting, and management consulting. The characteristic of services is that completion is scheduled within a relatively short period, and delays cause significant damage to clients. For example, if due diligence services for a company preparing for listing are delayed, the entire listing schedule can be disrupted, causing enormous damage. Atlas Legal considers the following in service contracts. First, client cooperation obligation clause: “The client must promptly provide materials and information requested by the contractor, and delays due to non-provision shall not be deemed the contractor’s fault.” Second, interim report and feedback clause: “The contractor shall regularly report interim results and receive the client’s feedback, and feedback delay periods shall be excluded from days of delay.” Atlas Legal recently handled a case where a due diligence contract between an accounting firm and a client was delayed by 3 weeks due to the client’s delay in providing materials, but because the contract had a clear provision, the accounting firm did not bear liquidated damages.

7. What should be reviewed when drafting contracts?

Liquidated Damages Clause Checklist

The following are the liquidated damages-related checkpoints that Atlas Legal always confirms when reviewing contracts:

Customized Clauses by Contract Type

Additional clauses should be included depending on the nature of the contract. Atlas Legal proposes the following customized clauses:

IT/Software Development Contracts

• Requirement change management: “Schedule adjustment after impact analysis when client makes written requirement changes”
• Stage-by-stage inspection: “Proceed to next stage after completing inspection at each milestone; exemption for inspection delays”
• Third-party service dependency: “Exemption for delays due to third-party service failures such as payment gateways, cloud services”

Construction Contracts

• Weather conditions: “Automatic schedule extension for weather conditions making work impossible (heavy rain, heavy snow, extreme cold, extreme heat)”
• Permit delays: “Exemption for period when permits the client agreed to obtain are delayed”
• Design changes: “Negotiate additional schedule when client requests design changes”

Manufacturing Contracts

• Raw material procurement: “Delivery adjustment when raw material supply is disrupted by force majeure”
• Advance payment linkage: “Automatic delivery extension when client fails to pay advance payment”
• Sample approval: “Sample production and approval period excluded from delivery period”

Documentation for Dispute Prevention

As important as the contract is documentation during performance. Atlas Legal recommends always documenting the following during contract performance. First, all requirement changes should be agreed upon in writing (including email). Oral agreements are difficult to prove later and are disadvantageous in disputes. Second, when requesting materials or information from the client, use methods with delivery confirmation (certified mail, email read receipt). Third, when force majeure circumstances arise, immediately notify the counterparty and collect supporting evidence (news articles, weather bureau data, government office documents). Fourth, exchange all inspection requests and approvals in writing. Many of the litigation cases handled by Atlas Legal involved parties unable to assert legitimate rights due to insufficient documentation. In particular, a Songdo manufacturing company had delivery delayed by one month due to the client’s advance payment delay but bore the full liquidated damages because they did not notify this in writing or document it.

8. How can liquidated damages disputes be prevented?

Advance Risk Assessment

It is important to thoroughly assess project risk factors before contract execution. Atlas Legal recommends the following risk assessment procedures. First, technical difficulty assessment. If new technology is involved or unverified methods must be used, the risk of schedule delays is high, so the liquidated damages rate should be lowered or the cap clearly set. Second, external dependency assessment. If there are many uncontrollable factors such as third-party cooperation, raw material supply, or permits, exemption clauses should be specifically enumerated. Third, client cooperation necessity assessment. If the client must provide many materials, information, or decisions, these should be specified in the contract with clear effects for non-performance. Atlas Legal recently negotiated a system integration project between a Songdo fintech startup and a bank, explicitly including the bank’s internal security review period (typically 1-2 months) in the contract schedule through advance risk assessment, preventing unnecessary liquidated damages disputes.

Balance Adjustment During Negotiation

If liquidated damages clauses are made unilaterally favorable only to the creditor, the counterparty may hesitate to execute the contract, or even if executed, the relationship may deteriorate. Atlas Legal proposes the following balance adjustment strategies. First, if a high liquidated damages rate is desired, set a low cap. For example, apply a high rate of 0.2% while lowering the cap to 20% to limit the contractor’s maximum risk. Second, if agreeing to a penalty, use rates at or below State Contracts Act standards. Since court reduction is impossible, lower the rate to maintain equity. Third, establish contractor protection mechanisms for client faults. While not as much as liquidated damages, specify effects (automatic schedule extension, additional cost claims, etc.) when the client fails to provide materials or delays inspection. Atlas Legal recently mediated contract negotiations between a major retailer and a logistics system developer, where the retailer wanted 0.15% and a penalty while the developer wanted 0.05% and liquidated damages. We reached a compromise at 0.1%, liquidated damages, 25% cap, and specified client inspection deadline (automatic approval deemed if not inspected within deadline).

Communication During Performance

Transparent and frequent communication during contract performance is key to dispute prevention. Atlas Legal recommends the following. First, regular progress reports. Report progress weekly or biweekly and share anticipated delay factors in advance. Second, early warning system. If schedule delay possibilities are detected, immediately notify the client and discuss causes and countermeasures. Notifying at the last moment leaves the client no time to prepare alternatives and deteriorates the relationship. Third, document changes. Document all requirement changes, schedule adjustments, additional work, etc. in meeting minutes or emails to eliminate room for future disputes. The most common problem Atlas Legal has observed while handling liquidated damages litigation is “said it verbally but have no documents.” In a recent case, the contractor claimed to have verbally requested materials from the client but had no evidence such as emails or meeting minutes, so the court did not recognize this and ultimately bore the full liquidated damages.

Response Strategy When Disputes Arise

When liquidated damages disputes arise, respond in the following steps. First, immediately consult with an attorney to identify legal issues. Review possibilities for liquidated damages reduction, client fault claims, and force majeure application. Second, collect evidence. Secure all emails, meeting minutes, work logs, and third-party documentation (weather bureau data, delivery proof, etc.). Third, attempt negotiation. Try to negotiate liquidated damages reduction or installment payments before litigation to save both parties’ costs and time. Fourth, proceed with legal procedures if negotiation fails. For liquidated damages, apply for court reduction and dispute the liquidated damages themselves by asserting client fault or force majeure. Atlas Legal recently handled a case where a small Songdo manufacturing company was charged 30 million KRW in liquidated damages, proving the client’s advance payment delay (14 days) and design changes (2 times, total 20 days required) to reduce actual days of delay by 34 days and lower liquidated damages to 9 million KRW. Additionally, by arguing that liquidated damages were excessive, we obtained further court reduction (30%) to a final payment of only 6.3 million KRW.

9. FAQ

Atlas Legal provides various corporate legal services in Songdo, Incheon, South Korea, including contract drafting, review, and dispute resolution. Liquidated damages clauses are a core mechanism for securing contract performance, and appropriate rates and caps can balance the interests of both parties. For complex or high-value contracts, it is important to consult with experts when designing liquidated damages clauses to prevent disputes and establish reasonable contractual relationships. Atlas Legal provides fair liquidated damages design based on State Contracts Act standards, along with all practically necessary clauses including force majeure exemptions, client fault exemptions, and change management to draft dispute-free contracts.