Construction licensing law draconian, possibly unconstitutional

In California, Business and Professions Code Section 7031(b) allows a person who utilizes construction services to sue for return of money paid if the contractor was not licensed at all times during performance of the contract - not just money paid during the unlicensed period is returned, all money paid must be disgorged. This law is draconian, vindictive and probably unconstitutional in at least some applications.

The Contractors State License Law (B&P Sections 7000 et seq.) is supposed to assure that those providing construction services possess a minimal level of responsibility.

But not every consumer of construction services needs that protection. The federal government does not; therefore, state license laws cannot be enforced on contractors hired by the federal government. Leslie Miller Inc. v. Arkansas, 352 U.S. 187, 189-90 (1956). Many other sophisticated users of construction services also do not need such protection, like many state and local agencies, large developers, and large contractors. For the time being, however, the law applies to all contractors on non-federal projects in California.

California authorizes four penalties for "engag[ing] in the business of, or act[ing] in the capacity of, a contractor" without a license - a criminal penalty, civil penalty, shield penalty and spear penalty.

The criminal penalty on the first offense is a misdemeanor conviction with a fine up to $5,000, plus restitution for any actual economic loss. The fine is payable to the government, the economic loss to the customer.

The civil penalty is a citation by the Registrar of Contractors, an administrative hearing, and a penalty up to $5,000, except for certain named violations. The civil penalty is payable to the government.

The shield penalty bars use of the courts to collect money owed to the unlicensed contractor for work performed. This penalty vindicates the judicial system by preventing use of it to enforce a contract performed in violation of law. That purpose outweighs the fact that the unlicensed contractor's customer sometimes get a windfall in excess of any actual damages suffered by the customer.

The sword penalty is disgorgement, allowing the customer to recover all payments made to the unlicensed contractor, in addition to any compensatory damages due for failure of the contractor to properly perform the work. The disgorgement, like the compensatory damages, is payable to a private party, not the government.

The confluence of the license law's shotgun approach and the draconian nature of disgorgement causes outrageous effects in some cases. Take these facts: An international general contractor on a $50 million construction contract subcontracts $4 million of the work to a national trade contractor. The subcontractor is a New York corporation, but during the project its assets, including the ongoing subcontract, are purchased by a Delaware corporation. The prime contractor timely consents to a subcontract assignment to the new firm. All of the subcontractor employees and equipment on the project remain the same throughout the job. The New York corporation's registered managing employee (RME) for its California contractors license becomes the RME for the Delaware corporation; however, logistics issues cause an 18-day gap between the time he withdraws as the New York corporation's RME and the time the Contractors State License Board recognizes him as the Delaware corporation's RME. The subcontract work is timely completed and is accepted as fully complying with the plans and specifications. However, a dispute remains over the subcontractor's $300,000 claim for extra work. Ultimately, the subcontractor sues. The prime contractor discovers the license gap, asserts the shield penalty as a defense against the $300,000 claim, and cross-complains for disgorgement of all $4 million paid to the subcontractor.

All four license penalties can be avoided if a contractor substantially complies with the license law. However, even though the RME, employees and equipment were the same throughout the project, the Delaware corporation probably lacks a substantial compliance defense. Technically, the Delaware corporation had never been a duly licensed contractor in California during the 18-day gap. The Delaware corporation also cannot assert equitable defenses, at least as to the shield penalty. See Alatriste v. Cesar's Exterior Designs Inc., 183 Cal. App. 4th 656, 672-73 (2010).

But, of course, enforcement of the license law is constrained by constitutional principles. Disgorgement is a form of damages assessed against the unlicensed contractor and paid to its customer for the violation of the license law and for the unlicensed contractor's deceit (either affirmatively or by non-disclosure of material facts). Disgorgement is neither a criminal penalty nor a civil penalty - it is a monetary award to a private party, not the government.

Punitive damages are independent from, and not in any way compensation for, any actual damages suffered. And regardless whether it is a legal or equitable remedy, and regardless what it is labeled, disgorgement is clearly a penalty, unrelated to actual damages, in the form of punitive damages paid to a private party.

California courts have repeatedly held disgorgement to be lawful - on its face - despite the potential harshness of the remedy. However, just as the Legislature allows juries to assess punitive damages under a statute that is clearly constitutional on its face, the courts routinely determine whether the punitive damages assessed by the jury in a particular case exceed constitutional bounds. The same must obtain for disgorgement.

The U.S. Supreme Court has established a three-part test for evaluating the validity of punitive damages: (1) the reprehensibility of the conduct being punished; (2) the reasonableness of the relationship between the harm and the award; and (3) the difference between the award and the civil penalties authorized in comparable cases See State Farm Mut. Auto Ins. Co v. Campbell, 538 U.S. 408, 418 (2003).

In our hypothetical case, use of the disgorgement sword to take anything more than nominal damages from the Delaware corporation, and to give it to the prime contractor, would fail:

First, the conduct is not very reprehensible. The entity changed its ownership, but in all other relevant respects remained the same throughout the job. Both configurations were properly licensed, but for that 18-day gap.

And second, the relationship between the harm and disgorgement of $4 million would be grossly disproportionate. The prime contractor claims no compensatory damages; the subcontractor's work met the plans and specifications and was accepted by the prime contractor. California and federal courts have constrained awards of punitive damages to a reasonable relationship to the actual damages suffered, usually a small multiple. See Bankhead v. Arvinmeritor Inc., 205 Cal. App. 4th 68, 88-89 (2012). In the hypothetical case, disgorgement of anything would be an infinite multiple of the non-existent actual damages. Besides, the prime contractor is not a member of the public who needs protection from incompetence and dishonesty in those who provide building and construction services. Although it has been held that general contractors are entitled to protection against illegal subcontract work by unlicensed persons (Lewis & Queen v. N. M. Ball Sons, 48 Cal. 2d 141, 152-54 (1957)), the prime contractor in the hypothetical is a sophisticated fellow contractor that does not claim that it suffered any harm whatsoever.

The difference between $4 million disgorgement and both the criminal and civil penalties authorized in comparable cases is astronomic. As noted above, the maximum criminal penalty is $5,000, plus restitution of actual economic loss, but the prime contractor suffered no actual loss whatsoever. Also as noted above, the maximum civil penalty that could be assessed by the Registrar of Contractors would be $5,000. Thus, a disgorgement of $4 million would be 800 times the maximum comparable criminal or civil penalty. In the hypothetical case, no punitive disgorgement damages in excess of $5,000 would pass constitutional muster.

Bernard Kamine is founder of Kamine Law PC, a firm that specializes in construction litigation, representing owners, contractors and design professionals.