Hello, this is Attorney Park Jong-Han of Cheongchul Law Firm.

When a construction contract is terminated mid-performance, several issues arise: the extent of the retroactive effect of termination, how the legal consequences differ depending on whether the contractor or the owner is at fault in default-based termination, and the legal effects of termination under Article 673 of the Civil Code as well as mutual rescission. We will examine these in turn.

[Question] Legal Effects of Termination of Construction Contracts

[Answer]

A. Retroactive Effect of Termination and Its Limitations

In general, when a contract is terminated, the contractual relationship is retroactively extinguished and the parties bear a duty of restitution. However, in construction projects, the prevailing view of both scholars and courts is that the retroactive effect is limited where restitution would cause significant social and economic loss and where the completed portion benefits the owner. That is, the contract becomes ineffective only as to the uncompleted portion, the contractor delivers the building to the owner in its state at the time of termination, and the owner is obligated to pay reasonable compensation for the delivered building considering its degree of completion (Supreme Court Decision dated Feb. 25, 1997, Case No. 96Da43454).

However, this limitation on retroactive effect does not always apply. Where the owner cannot have the work continued by a third party based on the completed portion, or where, as in plant construction such as waste treatment facilities at landfills or total-phosphorus treatment facilities at sewage plants, the required performance is not met, courts have recognized the full retroactive effect of termination on the principal ground that the completed portion does not benefit the owner (Supreme Court Decision dated Dec. 22, 1992, 92Da30160; Supreme Court Decision dated Aug. 12, 1994, 92Da41559; Seoul High Court Decision dated Feb. 21, 2020, 2018Na2044563, 2018Na2044570).

B. Default-Based Termination — Fault of the Contractor or the Owner

(1) Where the contract is terminated due to the fault of the contractor, the retroactive effect is typically limited, so (i) the contractor must deliver the building to the owner in the state existing at the time of termination, (ii) the owner must pay the contract price corresponding to the percentage of completion of the delivered building (Supreme Court Decision dated Feb. 25, 1997, 96Da43454). Further, (iii) if there is a liquidated damages clause for delay, the contractor bears liquidated damages for the period from the day after the contractual completion date (start) until the point at which the work could have been completed by another contractor following termination ('the time when termination could have been exercised', not the actual termination date) (end) (Supreme Court Decision dated Oct. 12, 1999, 99Da14846); and (iv) for losses unrelated to the delay (such as additional construction costs incurred to complete the work after suspension and termination), the contractor also bears liability for damages for default (Supreme Court Decision dated Nov. 26, 2002, 2000Da31885).

(2) Where the work was suspended due to the owner's conduct, such as the owner's failure to perform preparatory cooperative acts (designation and provision of the construction site, selection and supply of materials, etc.) or improper instructions causing the contractor to stop work, the contractor obtains a claim for the contract price against the owner by analogy to the provision on impossibility of performance due to the creditor's fault (Civil Code Article 538(1)). The contractor may then claim the full contract price; however, views differ on whether the actual claim amount equals the contract price minus any obligation the contractor is relieved from (Civil Code Article 538(2)), or whether the contractor may claim only the contract price corresponding to completed work plus damages caused by the owner's fault (the expected profit had the contract been performed normally). In either case, the substantive amount will not differ greatly.

Meanwhile, even where the contract is terminated due to the owner's fault, if the work would inevitably have been delayed due to reasons attributable to the contractor even absent the cause for termination, the owner may apply the liquidated damages clause and hold the contractor liable for delay (Supreme Court Decision dated Oct. 11, 2012, 2010Da34043, 34050).

C. Termination under Article 673 of the Civil Code

Article 673 of the Civil Code provides that "the owner may terminate the contract by compensating the contractor for damages before the contractor completes the work". Considering the non-substitutable nature of construction contracts that respond to a specific orderer's request, the provision allows the owner to freely terminate the contract on condition of compensating the contractor's damages when, after the contract's formation, the completion of the work becomes unnecessary to the owner due to changed circumstances.

Although the text reads "may terminate by compensating for damages," it is interpreted that the owner is not required to tender damages in advance in order to terminate. Also, since the above provision applies absent a special agreement between the parties, where the parties have reserved a right of termination by special agreement and the owner exercises that reserved right, the owner owes no duty to compensate the contractor for damages absent further agreement.

The scope of damages under the above provision, as with damages for default, encompasses all losses with a substantial causal relationship — typically the sum of the costs the contractor has already expended and the profit the contractor would have earned had the work been completed. Given the purpose of the provision, the owner may not assert comparative negligence or reduction of liquidated damages, but offset of benefits should be permitted (Supreme Court Decision dated May 10, 2002, 2000Da37296).

D. Mutual Rescission

Often, the parties mutually agree to terminate the contract after its conclusion, and such mutual rescission may be either express or implied. In practice, this mutual rescission is sometimes referred to as "gongsa tajeol" (construction settlement-termination)".

As with other contracts, in mutual rescission, damages for default may not be claimed absent special circumstances such as an agreement at the time of rescission that one party will compensate the other or a manifestation of intent to reserve the claim for damages (Supreme Court Decision dated Apr. 25, 1989, 86DaKa1147, 1148).

If the parties have agreed on settlement of the work-in-progress portion when rescinding by mutual agreement, that agreement governs. In addition, in mutual rescission, Article 548(2) of the Civil Code does not apply, so monies to be returned need not be increased by interest accrued from the date of receipt (Supreme Court Decision dated Jul. 30, 1996, 95Da16011).

Meanwhile, where mutual rescission occurs without any settlement agreement (common in cases of implied agreement), the question arises whether the contractor still holds a claim for the contract price corresponding to the work-in-progress, and the Supreme Court has affirmed this (Supreme Court Decision dated Feb. 25, 1997, 96Da43454).

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