Can We Agree on "Liquidated Damages" (Songai Baishōgaku no Yotei) in Our Japanese Contracts? How Are They Enforced?

Japanese Attorney at Law - Bengoshi L.L.

• 8 min read

In the often complex world of commercial contracts, anticipating and quantifying the precise financial fallout from a potential breach can be challenging and contentious. To address this, parties frequently seek to pre-determine the amount of compensation payable in such an event. In Japan, this practice is recognized and governed by the concept of "Liquidated Damages" (損害賠償額の予定 - Songai Baishōgaku no Yotei), primarily under Article 420 of the Civil Code. This article explores the nature, purpose, enforceability, and limitations of liquidated damages clauses in Japanese contracts.

What Are Liquidated Damages (Songai Baishōgaku no Yotei) in Japan?

Article 420, Paragraph 1 of the Japanese Civil Code allows parties to a contract to agree in advance on the specific amount of damages that will be payable if one party fails to perform its obligations (non-performance - 債務不履行 - saimu furikō). This pre-agreed sum is what constitutes liquidated damages.

For example:

  • A supply agreement might stipulate that if the seller fails to deliver a critical piece of machinery by the agreed date, the seller shall pay the buyer a fixed sum of ¥X million as liquidated damages.
  • A loan agreement could specify that if the borrower defaults on repayment by the due date, they will be liable for delay damages calculated at a pre-agreed daily or annual rate on the outstanding principal.

The Purpose of Liquidated Damages Clauses

The primary objectives of incorporating a liquidated damages clause into a contract are:

  1. Simplification of Proof: To obviate the often difficult, time-consuming, and expensive process of proving the actual occurrence and monetary extent of damages suffered due to a breach.
  2. Prevention of Disputes: To minimize potential disputes between the parties regarding the quantum of damages, as the amount is already fixed.
  3. Certainty and Predictability: To provide both parties with clarity and predictability regarding the financial consequences should a breach occur, allowing for better risk assessment and management.

Once a valid liquidated damages clause is in place, it has several significant legal effects:

Creditor's Burden of Proof is Reduced

If a breach occurs and the contract contains a liquidated damages clause, the non-breaching party (creditor) generally only needs to prove:

  1. The existence and terms of the valid liquidated damages agreement.
  2. The fact that the other party (debtor) committed the non-performance specified in the clause.

Crucially, the creditor is not required to prove that they actually suffered any damage, nor do they need to prove the actual amount of damage incurred. The stipulated sum becomes payable upon proof of breach, irrespective of the actual loss.

Judicial Non-Interference with the Agreed Amount (General Rule)

A key characteristic of liquidated damages under Article 420, Paragraph 1 is that, as a general principle, courts cannot increase or decrease the amount stipulated by the parties. Even if the actual damages proven are significantly higher or lower than the pre-agreed sum, the court is bound by the parties' prior estimation. This reflects a strong deference to party autonomy in commercial dealings. For instance, if a contract stipulates ¥10 million in liquidated damages for non-delivery, the breaching party cannot argue for a reduction even if the actual loss to the creditor was only ¥5 million, nor can the creditor demand more if their actual loss was ¥15 million.

Interaction with Debtor's Defenses

  • Exemption from Liability (e.g., Force Majeure): A complex issue is whether a debtor can avoid paying liquidated damages by proving that the non-performance itself was due to grounds not attributable to them (e.g., force majeure, as per the proviso of Article 415, Paragraph 1).
    • The dominant scholarly view in Japan has tended to argue that the debtor generally cannot raise such defenses to escape liability for pre-agreed liquidated damages. The reasoning is that liquidated damages clauses are often intended to provide a comprehensive settlement for non-performance, precluding subsequent disputes not only about the amount of damage but also about the cause or attributability of the breach.
    • However, a critical perspective suggests that if the underlying non-performance is itself excusable under general principles, the obligation to pay even liquidated damages should not arise. This view holds that the primary purpose of liquidated damages is to fix the quantum of damages for a culpable breach, not to create liability where none would otherwise exist. If, for example, delivery of specific goods becomes genuinely impossible due to an unforeseeable government embargo (for which the seller is not responsible), it is arguable that the seller should not be liable for liquidated damages stipulated for non-delivery.
  • Creditor's Comparative Negligence (過失相殺 - Kashitsu Sōsai): If the creditor's own fault contributed to the non-performance or the extent of the loss, can a Japanese court reduce the amount of liquidated damages based on the principle of comparative negligence (Article 418)?
    • Judicial Precedent: The Supreme Court of Japan, in a judgment on April 21, 1994 (Saibansho Jiho 1121-1), affirmed that courts can take the creditor's fault into account and reduce the stipulated liquidated damages amount, unless special circumstances indicate otherwise. This approach suggests that the principle of fairness in allocating loss due to shared responsibility can override the strict agreement on the sum.
    • Alternative Scholarly View: Some scholars argue against this, suggesting that if a primary purpose of liquidated damages is to ensure certainty and avoid judicial assessment of quantum, allowing reductions for the creditor's fault reintroduces judicial discretion and potentially undermines the parties' agreement. From this viewpoint, a reduction might only be appropriate in extreme cases where enforcing the full liquidated amount, despite significant creditor fault, would constitute an abuse of rights or be grossly contrary to good faith.

Effect on Other Remedies

The inclusion of a liquidated damages clause does not automatically bar the creditor from pursuing other remedies for the breach. Article 420, Paragraph 2 explicitly states that an agreement on liquidated damages does not prevent the creditor from demanding actual performance or exercising a right to terminate the contract.

The scope of the liquidated damages clause itself is key:

  • If the clause is specifically for delay damages, it will typically cover losses due to late performance but not losses arising from complete non-performance (e.g., due to impossibility) or from contract termination.
  • If it is for damages in lieu of performance (e.g., a sum payable if the contract is terminated for breach or if performance becomes impossible), it generally does not also cover separate damages for any preceding period of delay unless so specified.
  • If the clause is intended as a comprehensive settlement payment meant to cover all aspects of a breach and lead to the termination of the contractual relationship, its payment might preclude other monetary claims arising from that breach. The specific wording and intent of the clause are paramount.

Limitations on the Enforceability of Liquidated Damages

While Japanese law respects the parties' freedom to agree on liquidated damages, this autonomy is not unlimited. Several grounds can lead to such clauses being deemed unenforceable, either in whole or in part:

  1. Specific Statutory Restrictions: Certain Japanese statutes impose limitations on liquidated damages clauses in specific types of contracts, often to protect parties perceived to be in a weaker bargaining position. Examples include:
    • The Interest Limitation Act (Articles 4 and 7), which restricts penalty rates for overdue monetary obligations.
    • The Labor Standards Act (Article 16), which prohibits employers from pre-determining damages or penalties for breach of labor contracts by employees.
    • The Installment Sales Act (Article 6) and the Act on Specified Commercial Transactions (Article 10), which limit damages payable by consumers in certain contexts.
  2. Violation of Public Policy and Good Morals (公序良俗違反 - Kōjo Ryōzoku Ihan) (Article 90):
    A liquidated damages clause that is grossly excessive can be invalidated as contrary to public policy and good morals under Article 90 of the Civil Code. This is particularly relevant if the amount stipulated is so disproportionate to any conceivable actual loss that it effectively becomes a punitive measure, or if it was agreed upon under circumstances of duress, exploitation of a party's distress or inexperience (an "unconscionable act" or 暴利行為 - bōri kōi). The Great Court of Cassation (predecessor to the Supreme Court) recognized this principle in judgments such as that of April 8, 1932 (Minshu Vol. 11, p. 582) and March 14, 1944 (Minshu Vol. 23, p. 147).When a clause is deemed excessively high and contrary to public policy, there are differing views on the consequence:
    • Entire Clause Void Theory (条項全部無効説 - Jōkō Zenbu Mukō Setsu): One perspective argues that if the clause is fundamentally oppressive, the entire liquidated damages provision should be struck down as void. The court should not attempt to "rewrite" the contract by substituting a "reasonable" amount, as this could inadvertently encourage the inclusion of such clauses by stronger parties. In this scenario, damages would then be assessed based on the general rules of Article 416 (actual proven loss, subject to foreseeability).
    • Partial Invalidity Theory (条項一部無効説 - Jōkō Ichibu Mukō Setsu): A more commonly accepted view seems to be that only the excessive portion of the liquidated damages is void. The court may reduce the stipulated amount to a level it considers reasonable or not contrary to public policy, thereby upholding the parties' underlying intent to liquidate damages to some degree, while excising the oppressive element. However, if the clause is deemed exceptionally egregious or antisocial in its nature, even this approach might lead to the entire clause being invalidated.
  3. Insufficiently Low ("Nominal") Liquidated Damages:
    The question also arises whether courts can increase a liquidated damages amount if it is set at a nominal or unreasonably low level that bears no relation to potential actual losses. While the part of the old Civil Code Article 420(1) that explicitly forbade courts from increasing or decreasing the sum was removed in the 2020 Civil Code reforms, legal commentary suggests that judicial increase of a pre-agreed low sum is problematic. Such a clause functions more like a limitation of liability. Increasing it would be a significant interference with party autonomy, essentially imposing a higher liability than agreed. Such clauses are more appropriately scrutinized under the rules governing limitation of liability clauses (e.g., whether they are contrary to public policy, or unfair under consumer protection laws or rules for standard form contracts if applicable).
  4. The Consumer Contract Act (消費者契約法 - Shōhisha Keiyakuhō):
    This Act provides specific protections for consumers and directly impacts liquidated damages clauses in consumer contracts:
    • Article 9, Item 1: Voids clauses setting liquidated damages or penalties for a consumer's termination of a contract if the sum exceeds the average damages typically incurred by the business from such termination, considering the reason, timing, etc..
    • Article 9, Item 2: Voids clauses setting damages or penalties for a consumer's late payment if the sum exceeds 14.6% per annum on the overdue amount.
    • Article 10 (General Unfairness Clause): Even if a liquidated damages clause in a consumer contract is not caught by the specific provisions of Article 9, it can still be rendered void under Article 10 if it unilaterally impairs the consumer's interests in a way that contravenes the principle of good faith and fair dealing.

Penalty Clauses (Iyakukin)

The Japanese Civil Code also addresses "penalty clauses" (違約金 - Iyakukin). Article 420, Paragraph 3 establishes a presumption that a penalty is liquidated damages. This means that if a contract stipulates a "penalty" to be paid upon breach, it will generally be treated by the courts as a pre-estimation of damages and will be subject to the same rules and limitations as a liquidated damages clause. For example, the creditor would not need to prove actual loss, and the court would generally not adjust the amount.

It is theoretically possible for parties to agree on a penalty that is purely punitive in nature (a "true penalty" or 違約罰 - iyakubatsu), intended to be payable in addition to any actual damages suffered. However, to achieve this, the parties would need to clearly express this intent in the contract, and the party asserting that the clause is a true penalty (usually the creditor seeking both the penalty and actual damages) would bear the burden of rebutting the statutory presumption that it is liquidated damages. Furthermore, the Interest Limitation Act (Article 4, Paragraph 2) specifically deems penalty clauses related to monetary obligations as liquidated damages for the purpose of its restrictions.

Conclusion

Liquidated damages clauses (Songai Baishōgaku no Yotei) are a recognized and generally enforceable tool in Japanese contract law, offering parties a valuable mechanism for pre-determining compensation in the event of non-performance. They serve to simplify proof, reduce disputes, and enhance predictability. The core legal effect under Article 420 of the Civil Code is that the non-breaching party can claim the stipulated sum upon proving the breach, without needing to demonstrate actual loss, and courts will typically refrain from altering this agreed amount.

However, this principle of party autonomy is not absolute. Enforceability is subject to important limitations arising from specific statutes (such as the Consumer Contract Act and the Interest Limitation Act), overarching principles of public policy and good morals (which can invalidate excessively high or oppressive clauses), and judicial interpretations regarding the debtor's defenses, including the potential for reduction based on the creditor's comparative negligence. Penalty clauses, in most instances, are treated synonymously with liquidated damages. For businesses engaging in contracts under Japanese law, carefully drafted and reasonable liquidated damages provisions can be an effective way to manage risk, but awareness of these limitations is essential to ensure their validity and enforceability.