California Supreme Court Addresses “Good Faith” Construction Disputes Under Prompt Payment Laws

by Wendel, Rosen, Black & Dean LLP
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It’s been a rollercoaster. But the ride appears to be over.

In United Riggers & Erectors, Inc. v. Coast Iron & Steel Co., Case No. S231549 (May 14, 2018), the California Supreme Court addressed whether a direct contractor can withhold payment from a subcontractor based on the “good faith dispute” exception of the state’s prompt payment laws if the “dispute” concerns any dispute between the parties or whether the dispute must be directly relevant to the specific payment that would otherwise be due.

California’s Prompt Payment Laws

California has a number of construction-related prompt payment laws scattered throughout the state’s Civil Code, Public Contracts Code and Business and Professions Code. Their application depends on the type of construction involved, whether public or private; the type of payment involved, whether a progress payment or retention; and who is paying, whether it’s a private owner, public entity, direct contractor, or subcontractor.

While the application of these statutes vary they are structured similarly and provide for payment by a private owner, public entity, direct contractor, or subcontractor to lower-tiered parties within certain time-frames, ranging from seven days to 45 days. The failure to comply can subject these entities to prompt payment penalties of two percent per month, which exceeds the interest rate on many credit cards. Penalties, in other words, can be substantial.

However, each of these statutes provide a “good faith” or “bona fide” dispute exception, in which a higher-tiered party can withhold from a lower-tiered party up to 150 percent of any amount disputed in “good faith” or in which there is a “bona fide” dispute, without being subject to the prompt payment statute’s credit card-like penalties for non-payment.

At issue in United Riggers, was whether the good faith withholding exception applies to any disputes between the parties or only to disputes directly related to the payment that is due. Thus, for example, can a direct contractor who is back charging a subcontractor for defective work withhold up to 150 percent from a pay application submitted by that subcontractor, or is the good faith withholding exception limited to disputes related to that specific pay application?

In United Riggers, the California Supreme Court, addressing this issue with respect to one of the state’s prompt payment statutes, Civil Code section 8814, found that the good faith withholding exception only applies if there is a “good faith” dispute as to a specific pay application.

United Riggers & Erectors, Inc. v. Coast Iron & Steel Co.

In 2010, Universal Studios, LLLP contracted with Coast Iron & Steel Co. to provide “miscellaneous metals” work for Universal Studio’s new at-the-time Transformers ride, creatively named, Transformers: The Ride, which ultimately opened in May 2012. Coast, in turn, subcontracted with United Riggers & Erectors, Inc. to perform work on The Ride.

Not atypically, Coast’s subcontract with United provided that Coast would withhold 10 percent of amounts billed by United as retention to be paid at the end of the project. At the end of the project, Coast owed United $149,602.52 in retention.

At the end of the project, Coast sent an email to United requesting that United submit its final change order log together with any outstanding change order requests. In response, United sent a letter to Coast demanding $274,158.40 as compensation for “the mismanagement and or delayed deliveries caused by Coast” as well as $78,384 in outstanding change order requests. In response, Coast sent an email to United stating, “I will see you in court!!” Apparently, the ascent to the top of the rollercoaster had been reached.

In January 2013, United filed suit against Coast seeking $446,857.42 in damages comprised of $149,602.52 in retention, $23,186.50 in unpaid change orders, and $274,068.48 in damages attributed to “missing parts, lack of communications by Coast, fabrication errors, delays in installation of steel and lack of transportation access.” United also alleged that Coast was subject to prompt payment penalties under Civil Code section 8814, which requires that direct contractors pay their subcontractors retention within 10 days after receipt of payment from the owner or be subject to prompt payment penalties of two percent per month unless there is a “good faith dispute.”     

Three weeks after the case was filed, Coast paid United two-thirds of its retention, and ten months later paid the balance of the retention. However, these payments did not moot United’s prompt payment penalty claim because Civil Code section 8814, like most but not all of the state’s prompt payment penalty statutes, permits the prevailing party to recover its reasonable attorney’s fees and costs.

Following a bench trial, the trial court issued a statement of decision denying relief to United on all of its claims, finding that United had failed to follow the subcontractor’s procedures for submitting change orders and that United had failed to show that Coast was responsible for the extra expenses incurred by United. The trial court further found that prompt payment penalties were not appropriate because “there was a good faith dispute between Coast and United . . . that entitled Coast to withhold the payment of retention.”

On appeal, the Second District Court of Appeal affirmed as to United’s common law claims but reversed as to United’s statutory claim under the prompt payment statute, finding that limiting the good faith withholding exception to disputes specifically related to the specific payment at issue was more consonant with what the state legislature had contemplated when enacting the prompt payment statute. Thus, Coast could not use the parties’ dispute over mismanagement of the project as the basis for a good faith withholding of United’s retention. The Second District’s decision contributed to an already existing split of authority between appellate courts over interpretation of the good faith withholding exception of the state’s prompt payment penalty statutes.

The Supreme Court Decision

Describing the payment provisions contained in nearly all construction contracts, whereby, as a project reaches various stages of completion, “progress payments” are made by higher-tiered parties to lower tiered parties, with “retention” withheld from a portion of the progress payment until completion of the project, the California Supreme Court explained that progress payments provide contractors with the necessary cash flow to keep a project moving forward while retention provides higher-tiered parties with some protection from the risk of non-performance and is an incentive for lower-tiered parties to complete a project.

But, explained the Supreme Court, while contract and common law historically governed the details of progress payments and retention on construction projects, contractors would sometimes face challenges when negotiating payment terms that ensured prompt payment to them, particularly during tough economic times when higher-tiered parties have more leverage. As such, explained the Supreme Court, the State Legislature enacted a series of prompt payment statutes beginning in 1990 to discourage owners and higher-tiered contractors from withholding payments from lower-tiered parties as a way of granting themselves what were essentially interest-free loans.

But while the prompt payment statutes were designed to facilitate prompt payment to lower-tiered parties, the right to prompt payment is not unconditional, and a higher-tiered party can withhold payment from a lower-tiered party if there is a good faith or bona fide dispute. Some of these statutes, explained the Supreme Court, clearly provide that the good faith or bona fide dispute must concern a dispute relevant to the specific payment itself. In other words, the dispute must concern the work underlying the specific pay application for which payment is sought.

However, the prompt payment statute at issue, Civil Code section 8814, merely states that in cases of a “good faith dispute” the direct contactor may withhold up to “150% of the estimated value of the disputed amount,” without reference to whether the good faith dispute must concern the work underlying the specific payment sought or whether the good faith dispute could involve any dispute between the parties.

Looking at other similar prompt payment statutes, the underlying purpose of the prompt payment laws, and the legislative history of the various prompt payment statues including Civil Code section 8814, the Supreme Court held that in order for a direct contractor to withhold payment under the good faith witholding exception of Section 8814 the good faith dispute must concern a dispute relevant to the specific payment that would otherwise be due.

While the language of Civil Code section 8814 is prone to competing constructons, stated the Supreme Court, “statutes relating to the same class of things, and sharing the same purpose or object, should be harmonized and construed similarly.” And, here, explained the Supreme Court, when drafting the good faith withholding exception in other similar prompt payment laws, “the Legislature drafted the dispute exception in these statutes using language that plainly limits witholding to circumstances in which the dispute relates to the specific amount or payment at issue.”

Moreover, stated the Supreme Court, looking at the underlying purpose of Civil Code section 8814, “reading the statute in light of its broader purpose, as we must, supports the conclusion that oly witholding for disputes over the retention payment itself is allowed” since the underlying aim of the statue is “to ensure that parties who supply work or materials on projects, and who otherwse might lack leverage, are timely paid, and to provide them recourse in the event that they are not.”

Furthermore, explained the Supreme Court, were Civil Code section 8814 be interpreted to allow a direct contractor to withhold 150% of a disputed amount for “any” dispute, it could create a windfall for the direct contractor. Using the United’s claim of $274,158.40 for Coast’s alleged mismanagement on the project as an example, the Supreme Court explained that if Coast’s withholding of 150% of this amount or $411,237.60 were a proper good faith withholding, United would be unable to recover both the $274,158.40 it was claiming and Coast would able to keep $411,237.60 in retention that it never disputed was owed.

Finally, explained the Supreme Court, Civil Code section 8814 was modeled after former Civil Code section 3260, and legislative bill analyses reveal that the various iterations of former Section 3260 were designed to require timely payment of all “amounts due about which there is no good faith dispute” and, further, that when read in connection with Civil Code section 8816 which provides that when a contractor gives notice that work in dispute has been completed in accordance with the contract, the owner or direct contractor, upon acceptance of the disputed work, shall pay the portion of the retention relatigto the disputed work, it is clear that “the good faith disputes that justify withholding are those that relate to the work for which the retention is payment.”

Conclusion

United Riggers resolves the split of authority between Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc. (2009) 179 Cal.App.4th 1401, which held that any bona fide dispute can justify witholding of retention, and East West Bank v. Rio School Dist. (2015) 235 Cal.App.4th 742, which held that only disputes related to the retention’s security functions can justify witholding payment. Furthermore, while United Riggers concerned a dispute over the correct interpretation of Civil Code section 8814, the breadth of the Supreme Court’s ruling would appear to put an end to similar interpretation issues under other prompt payment statutes. For higher-tiered parties who occasionally pull out the “good faith” witholding ticket when justifying non-payment to lower-tiered parties, it appears to be the end of that ride, at least when it comes to a dispute that is not directly related to the specific payment that is otherwise due. Here’s a secret though: some prompt payment statutes are waivable in writing.

Photo credit: Warner Bros. Pictures

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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