“Good Faith” May Not Be Good Enough: California Supreme Court to Decide When General Contractors Can Withhold Retention

by Sheppard Mullin Richter & Hampton LLP

It is industry standard in California for owners of a construction project to make monthly payments to a contractor for work it has completed, less a certain percentage that is withheld as a guarantee of future satisfactory performance. This withholding is called a retention. Contractors generally pass these withholdings on to their subcontractors via a retention clause in the subcontract. Under such clause, if a subcontractor fails to complete its work or correct deficiencies in its work, the owner and the general contractor may use the retention to bring the subcontractor’s work into conformance with the requirements of the contract.

When and how retention payments must be released are governed by, among other statutes, Civil Code section 8800 et seq. Specifically, Civil Code section 8814, subdivision (a), states that a direct contractor must pay each subcontractor its share of a retention payment within ten days after the general contractor receives all or part of a retention payment. Failure to make payments in accordance with Section 8814 can subject an owner or a contractor to a (1) two percent penalty per a month on the amount wrongfully withheld, and (2) claim for attorney’s fees for any litigation required to collect the wrongfully withheld retention payments. (Civ. Code, § 8818.)

However, there exists an important exception to the ten-day deadline: whenever a “good faith dispute exists between the direct contractor and a subcontractor,” a direct contractor may withhold from the subcontractor’s retention an amount not in excess of 150 percent of the estimated value of the disputed amount. (See Cal. Civ. Code, § 8814, subd. (c) (Section 8814(c)).) There is very little in the statute or case law, however, defining what constitutes a “good faith dispute” sufficient to justify withholding funds from the retention.

The California Supreme Court has decided to fill this void, and granted a petition for review in United Riggers & Erectors v. Coast Iron & Steel, Case No. S231549 (United Riggers). The California Supreme Court certified the issue of whether “a contractor [may] withhold retention payments when there is a good faith dispute of any kind between the contractor and a subcontractor, or only when the dispute relates to the retention itself in the case of.”

In United Riggers, 243 Cal.App.4th 151 (2015), the General Contractor, Coast Iron & Steel Co. (Coast), entered into a direct contract with an owner and a subcontract with United Riggers & Erectors (United). After the work was completed, and after Coast received its retention from the owner, Coast continued to withhold United’s retention on the ground that United had submitted various change order requests and damage claims that Coast disputed, citing Section 8814(c)’s good faith provision.

The Court of Appeal disagreed with Coast and held that this was not permissible under Section 8814(c), holding “a contractor is entitled to withhold a retention payment only when there is a good faith dispute regarding whether the subcontractor is entitled to the full amount of the retention payment.” (Emphasis added.) The Court of Appeal then remanded for an assessment of interest and attorney’s fees due to United for the delayed retention payment claim. In reaching this conclusion, the Court of Appeal reasoned that “[t]o excuse Coast in this case from paying United the retention payments would unduly increase the leverage of owners and primary contractors over smaller contractors and subcontractors by discouraging subcontractors from making legitimate claims for fear of delaying the retention payment.” Such a consequence was not to be borne, the Court of Appeal explained, in light of the “broader remedial purpose of the prompt payment statutes” to “encourage general contractors to pay timely their subcontractors and to provide the subcontractor with a remedy in the event that the contractor violates the statute.”

This policy concern was the primary focus of the California Supreme Court at the oral argument in United Riggers, which took place on March 6, 2018. Coast’s counsel began with a “plain meaning” analysis of Section 8814(c), juxtaposing its language with Civil Code section 8812—which expressly states that retention payments may only be held when “there is a good faith dispute between the owner and direct contractor as to the retention payment due.” (Emphasis added.) This predicated Coast’s argument that if the Legislature intended to limit the scope of disputes between direct contractors and subcontractors to those relating to the retention itself in Section 8814, the Legislature would have done so as it did in Section 8812 related to owners and direct contractors. The Court pushed back against this construction of the statute, positing whether under such interpretation, a general contractor would be able to withhold retention payments for a dispute related to any issue, even one outside the scope of the contract, such as a property border dispute. If this were the case, Justice Kruger cautioned, such interpretation would allow contractors to leverage the disbursement of retention payments to resolve separate disputes on unrelated projects.

The case has been submitted, and an opinion is expected to be issued in approximately 90 days. The opinion will certainly have wide-reaching effects in the construction industry. Namely, in the common event of contractor and subcontractor disputes, contractors will have to be cautious in assessing offsets against the retention, particularly in situations where the dispute involves mixed claims of changed and delayed work and subcontractor deficiencies, lest they be liable for prompt payment penalties and attorneys’ fees.

This is the first of a two blog post series. Our second post in this series will analyze the United Riggers decision as soon as it is issued.

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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