State Supreme Court mends split on contractor-subcontractor disputes

CONSTRUCTION CORNER

In United Riggers & Erectors, Inc. v. Coast Iron & Steel Co., 2018 DJDAR 4487 (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.

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?

Addressing this issue with respect to one of the state's prompt payment statutes, Civil Code Section 8814, the court found that the good faith withholding exception only applies if there is a "good faith" dispute as to a specific pay application.

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; who is paying, whether it's a private owner, public entity, direct contractor or subcontractor; and the type of payment involved, whether a progress payment or retention. "Progress payments" are made by higher-tiered parties to lower-tiered parties, with "retention" withheld from a portion of the progress payment which is held until completion of the project.

While the applications 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 timeframes, ranging from seven to 45 days, the failure of which can subject these entities to prompt payment penalties of 2 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 nonpayment.

The Case

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, "Transfomers: The Ride." 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. Coast owed United $149,602.52 in retention by the end of the project.

After completion, Coast requested that United submit its final change order log together with any outstanding change order requests.

United responded 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 an email, Coast replied, "I will see you in court!!" Apparently, the top of the rollercoaster had been reached.

United sued 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 2 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 10 months later paid the balance. However, these payments did not moot United's prompt payment penalty claim because Section 8814, like most, but not all of the state's prompt payment penalty statutes, permits the prevailing party to recover its reasonable attorney fees and costs.

Following a bench trial, the trial court denied 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."

The 2nd 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. 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 2nd 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.

Supreme Court Decision

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 with some protection from the risk of nonperformance and as an incentive for lower-tiered parties to complete a project.

But the court said that 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, the California 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.

Although 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. The court said some of these statutes 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, Civil Code Section 8814 -- the statute at issue -- 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 similar statutes, the underlying purpose of the prompt payment laws, and the legislative history of the various prompt payment statues including Section 8814, the Supreme Court held that in order for a direct contractor to withhold payment under the good faith withholding 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 Section 8814 is prone to competing constructions, the court noted that "statutes relating to the same class of things, and sharing the same purpose or object, should be harmonized and constructed similarly." Here, when drafting the good faith withholding exception in other similar prompt payment laws, "[t]he Legislature drafted the dispute exception in these statutes using language that plainly limits withholding to circumstances in which the dispute relates to the specific amount or payment at issue."

Moreover, the court said "reading the statute in light of its broader purpose, as we must, supports the conclusion that only withholding 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 otherwise might lack leverage, are timely paid, and to provide them recourse in the event that they are not."

Furthermore, allowing a direct contractor to withhold 150 percent of a disputed amount for "any" dispute 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 percent 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, the court said 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 related to 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., 179 Cal. App. 4th 1401 (2009), which held that any bona fide dispute can justify withholding of retention, and East West Bank v. Rio School Dist., 235 Cal. App. 4th 742 (2015), which held that only disputes related to the retention's security functions can justify withholding payment. 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" withholding ticket when justifying nonpayment to lower-tiered parties, it appears to be the end of that ride. At least when it comes to a dispute, whether in good faith or not, that is not directly related to the specific payment that is otherwise due.