Hello, this is Attorney Park Jong-han from Cheongchul Law Firm.

In the case of a construction contract, there are situations where the contractor pays in advance for the amount to be paid later to facilitate the smooth execution of the contract, and this is referred to as an advance payment. Since such advance payments are made before the contractor executes the contract or before the payment is due, the issue arises as to how to handle the advance payment if the contractor receives it and the contract is terminated.

This also applies to national contracts, so if the contracting party receives a contract from the ordering agency and has received the advance payment but the contract is terminated, it is necessary to examine how the already paid advance payment is handled.

[Question]

How to handle advance payments after contract termination

[Answer]

Article 38 of the Ministry of Planning and Finance's Contract Guidelines stipulates the return of advance payments, stating that "the contractor must promptly request the return of the advance payment balance, and if returned due to the contractor's fault, the contractor will additionally claim the amount of accrued interest on the advance payment balance" (Article 1), and "if there is an unpaid amount for progress payments, the advance payment balance will be used to cover the unpaid amount first" (Article 4).

Therefore, examining the principle of handling advance payments after contract termination, the so-called advance payments received in construction contracts are a partial amount of the construction payment that the contractor pays in advance to allow the contractor to proceed with the work smoothly, and although it is not paid concerning specific progress, it is paid concerning the entire work. However, in light of the nature of advance payments, if a reason arises that the contractor must return the advance payment due to termination or breaches of conditions, without special circumstances, the unpaid amount of construction payment corresponding to progress achieved until that time will naturally be offset by the advance payment, and if there are remaining amounts of construction payment, the contractor is obliged to pay that amount only (Supreme Court ruling on September 20, 2007, case 2007Da40109, and ruling on December 7, 1999, case 99Da55519).

If in the case of a contract subcontracting is carried out and subcontract payment must be paid directly, Article 35, Paragraph 1 of the Construction Industry Basic Act and Article 14, Paragraph 1 of the Act on Fair Subcontracting provide regulations on direct payment of subcontract amounts. This is intended to protect subcontractors in a weaker position in the event of the contractor's bankruptcy or inability to pay or dispense subcontract amounts, and to effectively guarantee the compensation for project execution, but it does not assume the establishment of a direct contractual relationship between the contractor and subcontractor. Ultimately, the portion constructed by the subcontractor can only be regarded as part of the contractor's performance. Additionally, since the subcontractor is merely an auxiliary executor for the contractor, the construction amount achieved by the contractor must necessarily include the performance portion of the subcontractor as its helper. Therefore, if reasons such as contract termination or rescission arise after an advance payment has been made, the contractor's performance must deduct the construction payment concerning the subcontractor's performance from the advance payment, and only if there remains construction payment should the contractor directly pay the subcontractor for the subcontract amount (refer to the Supreme Court ruling on September 20, 2007, case 2007Da40109).

On the other hand, if an exceptional adjustment agreement is made for excluding subcontract amounts from the progress payment details subject to the advance payment, the determination of the details of the progress payment subject to advance payment must follow the agreement between the parties to the construction contract (see the Supreme Court ruling on November 26, 2004, case 2002Da68362). Therefore, within the recognized scope of reasons for directly paying the subcontract amount to the subcontractor, the contractor cannot evade the obligation to pay the subcontract amount to the subcontractor simply because the uncalculated advance payment has been applied to the progress payment

(refer to the Supreme Court ruling on May 13, 2010, case 2007Da31211). However, this adjustment agreement should be regarded, unless there are special circumstances, as an agreement aimed at protecting the subcontractor over the contractor, within limits that do not impose a new burden exceeding the contractor's debt obligations. If the advance payment is applied to eliminate the contractor's payment obligations before the reason for direct payment arises, the contractor will no longer have an obligation to pay the subcontract amount to the subcontractor. (Refer to the Supreme Court ruling on January 23, 2014, case 2013Da214437).

As such, we briefly examined the handling of advance payments in case of contract termination after payment. In disputes related to national contracts and public procurement, the relevant laws are very complex and subject to frequent amendments, so familiarity and experience are necessary, along with knowledge of interpretations and administrative rulings beyond just court decisions. Therefore, we strongly recommend seeking the help of an attorney with expertise in national contract laws and a range of experience in resolving disputes related to national contracts and procurement.

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