Civil Code amendment: Warranties in ukeoi contracts

While the amendment of the Civil Code will be effective on April 1, 2020, one of the major changes in the amendment is statutory warranties, often called latent or hidden defect protections.  In particular, you may often encounter warranty clauses in your commercial contracts for products and services such as software or website development, construction of tenant improvements, or sale or purchase of product components.  As this amendment impacts interpretation of warranties in contracts (called ukeoi) as well as sale and purchase agreements, we will first explain what ukeoi contracts are, and then discuss possible impacts of the amendment on statutory warranties.

What is a ukeoi contract?

A ukeoi contract is a kind of contract where a contractor promises to complete certain work that is undertaken in consideration for fees to be paid for the completed work.  Typically, this is often to create and hand over tangibles or intangibles, such as building construction, tailored clothes, or software development, but also includes service contracts such as laundry, car repair, house moving, haircuts, and transportation.

As ukeoi covers a variety of different contracts, it is sometimes difficult to distinguish it from other kinds of contracts.  For example, inin (or jun-inin), meaning entrustment, is concluded where a client requests a service provider to conduct certain legal or administrative matters, and the service provider accepts the same.  This can be for fees or without fees, and does not always come with the authority to act on the client’s behalf. Professional services, such as business consulting, legal counselling, IT support and maintenance are usually classified as inin (or jun-inin) contracts.  However, it is sometimes hard to classify projects into the right categories, especially when they are paid on a milestone or contingent fee basis.

To distinguish ukeoi and inin, it is important to look into whether parties have agreed, or if not explicitly agreed, whether it is natural to expect to pay or be paid only upon the completion of certain undertakings, or otherwise compensated regardless of certain results or outcomes.  If the payment is contingent upon a completion of certain things, it is more likely to fall under ukeoi contracts.

Why does the classification matter?

Civil Code has a number of codified rules applicable to different kinds of contracts.  These default rules can vary depending on how a contract is classified. For example, ukeoi is allowed to use a subcontractor, whereas inin is not unless otherwise agreed by the other.  Nevertheless, in most cases these rules are merely to supplement parties’ intention, and they do not take precedence of your explicit covenants.

Amendment in warranties

Previous Civil Code versions had a set of warranty provisions only applicable to ukeoi contracts.  Having removed these particular provisions, the new Code applies warranty provisions in sale and purchase contracts to ukeoi contracts mutatis mutandis.  Thus, we should turn first to the changes in warranty provisions for sale and purchase contracts.

New warranty framework

Statutory warranties in the Civil Code address various issues, such as shortage of quantity, latent defects in objects, ownership title issues, and legal encumbrances.  

In the new legislation, these are consolidated into two categories: physical conformity and legal conformity.  Physical conformity becomes an issue if the “nature, quality, or quantity of a subject matter is not conforming to what have been agreed in a contract”.  Legal conformity arises when the rights and interests transferred to a purchaser do not conform to what have been agreed in a contract. In either case, a purchaser may request, as its remedies, to (i) repair, replace, or deliver the shortage to complete the promise, (ii) reduce the consideration with or without notice (under certain conditions), (iii) be compensated for its damages, and/or (iv) terminate the contract.

Warranty period

Previously, a purchaser must exercise recourse available under the statutory warranty within one year from being aware of the factual basis to trigger the warranty.  Under the new legislation, if an issue is about the nature or quality of a product, a purchaser has to notify a seller of the issue in good faith within one year from being aware of such non-conformity, but does not need to exercise the recourse within that period.  This restriction does not apply to warranties for other reasons; they will be governed by general rules on statute of limitation.

Latent defect

The Civil Code provides that a purchaser may terminate a purchase contract if the purchaser is unable to meet the purpose of the contract due to a latent defect in the subject matter.  A latent defect also gives rise to a damage claim by the purchaser. The rationale of this was, albeit controversially, that a defect in a specific subject of the sale and purchase can only be remedied with a damage compensation or rescission of the contract.  This stems from a conventional notion that unique tangibles and common tangibles should be treated differently; the former is a unique object in the world (e.g., real estate) and therefore cannot be replaced or repaired once it is delivered to a purchaser, whereas common tangibles can be simply replaced if delivered objects have some defects in them.  Due to that distinction, a conventional view interprets that the provision on latent defects is applicable only for unique (=specific) tangibles, whereas defects in common tangibles simply give rise to a breach of contract. Apparently, over the hundred years since the Civil Code was enacted, many formerly handmade products are now manufactured in mass production.  Over the years, the unique/common distinction has lost its significance as it no longer is of particular importance to differentiate remedies depending on the nature of objects.

The new legislation ended this controversy by unifying the concept of warranty as “nature, quality, or quantity of a subject matter is not conforming to what have been agreed”.  With this, no matter what the subject matter is, unique or common, a seller is subject to warranty obligation if it fails to deliver what it has promised. Similarly, a defect no longer has to be “hidden”, meaning it would not be detectable with ordinary care.  In that sense, the amendment made warranty very simple and comprehensive, as it is now considered as a variation of claims available for a breach of contract.

On the other hand, this amendment appears to blur the distinction traditionally developed between warranty and breach of contract.  Previously, once a seller delivered products to a purchaser, even if the products had some quality issues, it was generally considered that the seller had performed its obligation to deliver the products.  Once the seller fulfilled its obligation to deliver the products, it was excused from breach of the contract, but remained subject to warranty obligations in case the products had defects. In that sense, it was important to define the concept of “delivery” as this transforms seller’s liability from breach of contract to warranty obligations.  This was especially so in ukeoi contracts as the delivery was often a condition for a contractor to receive payments for the work undertaken.

After the amendment, it might be less significant to distinguish breach of warranty or contract in the above circumstances.  If a seller delivers defective products to a purchaser, the seller is required to fulfill its obligation by either repair or replace them anyway.  In the new Code, a purchaser may request repair, replacement or otherwise a discount under the statutory warranty, as well as make a claim for damages or termination of a contract.  A purchaser might have an option to choose, in exercising its remedies, whether to rely on breach of contract or statutory warranty.

Warranties in ukeoi contracts

Under the new legislation, warranties in ukeoi contracts primarily rely on warranty provisions in sale and purchase contracts.  As such, the warranty framework described above in sale and purchase contracts will similarly apply, with the following exceptions.

The first exception is client materials and instructions.  When a client provides materials or instructions to a contractor, it may not claim warranties if non-conformity is due to such materials or instructions unless the contractor was aware that they were not suitable.

The second exception is warranty period.  Under the current Code, a client has to exercise warranty claims within one year from delivery of deliverables or completion of work if delivery is not required.  Under the new legislation, this is extended to one year from a client noticing non-conformity in deliverables or work completed. In addition, the client does not have to exercise its remedies within one year of noticing the problem, as long as it puts the contractor on notice within that deadline.  As such, if there is a defect that cannot be expected to be discovered easily, a client may exercise the warranty after one year from delivery.

In software development, for example, if a customer could not find defects that are not conforming to the agreed specifications in software even with its reasonable care and diligence, it may possibly exercise warranty claims after one year from the delivery of the software.  In practice, however, it may be unusual that a customer could not find an error for a while if it uses the delivered software regularly. In any event, it may become more important to set out an explicit warranty period that is not driven by the customer’s awareness in your contract.

How this amendment will impact my contract practice?

The amendment made in statutory warranty is to follow a modern approach that has recently become more common.  In that sense, the concepts newly adopted in the amendment, such as a conformity to parties’ agreement, may add some clarity to, and even resolve, some controversial topics that have been argued over decades.  

As a matter of practice, parties may try to articulate their expected outcome and deliverables in more detail, as it is now clear that they can seek recourse against the other if deliverables do not meet the agreed standards.  As mentioned above, parties may often run into a choice of whether to rely on warranty claims or assert a breach of contract depending on circumstances.

Although they were sometimes discussed as part of damages, the amendment formally codified partial reduction of fees as one of the remedies for warranty breaches.  A client may rely on this immediately where a request to repair or correct defects does not make sense (e.g., a contractor explicitly refuses to repair, the defects are of a nature that are unable to be repaired).

This may raise a difficult question, when a customer hires another contractor to finish work because it loses trust in the original contractor, of whether it may reduce fees up to the amount it has paid to another contractor.  The amended code also provides that a contractor may receive fees proportionate to the portion of the work it has completed where the work is divisible and to the extent useful to the customer, even if the work cannot be finished entirely or the contract is terminated before completion of the work.  This provision may prevent the customer from deducting all additional expenses incurred by hiring another contractor. We have to wait to see how this issue will be resolved in future.