Ruling is bad news for contractors and their sureties

Ruling is bad news for contractors and their sureties

The 2nd District Court of Appeal's March 11 decision in Karton v. Ari Design & Construction, Inc., 2021 DJDAR 2219, will have a major impact on the approximately 300,000 licensed contractors in California. Not in a good way. The case is bad law underpinned by bad public policy.

Karton, a homeowner and an attorney, contracted with Ari Design for a home remodel. Wesco wrote Ari's $12,500 contractor's license bond. A dispute arose and Karton sued Ari, Wesco and others. Karton claimed Ari overbilled him $35,096. Ari admitted to owing $13,000.

Thus, the dispute was seemingly over $22,096.

Wesco tendered its defense to Ari's counsel. During trial, evidence was presented that, contrary to Ari's assertion that it had no employees -- and therefore was exempt from paying worker's compensation insurance -- some of its employees testified at trial. As a result, the trial court determined that Ari was unlicensed during construction because it hadn't carried worker's compensation insurance. Finding Ari to be unlicensed, the court awarded the entire amount Karton paid to Ari -- $92,651 -- under Business and Professions Code Section 7031(b), which provides that, "a person who utilizes the services of an unlicensed contractor may bring an action in any court of competent jurisdiction in this state to recover all compensation paid to the unlicensed contractor for performance of any act or contract."

The trial court also awarded Karton $2,850 in storage fees plus treble damages of $10,000 under Code of Civil Procedure Section 1029.8 (damages under that section are capped at $10,000). Section 1029.8 also allows the court to award attorney fees and costs. Karton sought $271,530 in attorney fees against both Ari and Wesco. Finding that Karton had overlitigated the matter and engaged in uncivil practices, the trial court reduced the fee request to $90,000. The trial court awarded Karton all of the above damages ($195,501) against Ari and $12,500 against Wesco, ruling that there was no statutory or contractual basis to award attorney fees against it.

Karton appealed both the amount of fees awarded and urged the court of appeal to impose the fees against Wesco as well as Ari. The court affirmed the fee award against Ari, but reversed the trial court and awarded the same amount -- $90,000 -- against Wesco.

This is truly an astonishing holding. It is my understanding that Wesco is filing a petition for rehearing and/or a request for depublication. The petition should be granted and depublication ordered.

In its opinion, the appellate court refers to the Wesco bond as a "construction bond." Surety and construction lawyers understand that a construction bond is a bond underwritten for a specific public or private works project. There are two components of construction bonds: (1) a performance bond which guarantees to the owner that the contractor (principal) will complete the project in accordance with the terms of the underlying construction contract; and (2), a payment bond which guarantees that the contractor will pay its subcontractors and suppliers. See Civil Code Sections 8602 (private works) and 9550 (public works). The contractor's license bond at issue in Karton is a statutory bond required of licensed contractors as a condition of licensure. Bus. & Prof. Code Section 7071.6. Unlike a construction bond, where the project owner (or direct contractor if the bond is given by a subcontractor) is the named beneficiary or obligee, the license bond is written on a form approved by and given to the registrar of contractors. It is for the benefit of certain defined classes of beneficiaries including homeowners, laborers (wages) and union trust funds (fringe benefits). Bus. & Prof. Code Section 7071.5.

The failure by the Court of Appeal to recognize this distinction lies at the heart of why the case was wrongly decided. Contractor's license bonds are required for every licensed contractor -- no matter how large or small -- in the state. License bond sureties typically write them in exchange for a signed indemnity agreement and an annual premium of approximately $300. The bond premium is the same regardless of the size or experience of the contractor. In this way, even the smallest contractor can afford the bond and the surety's risk (now $15,000) is relatively modest as well. This encourages licensure -- and therefore regulation by the license board which is designed and intended to protect the public from violations of the license law by licensed contractors.

In contrast, construction bonds are underwritten for a specific project and a specific contractor. In doing so, the surety underwriter will ask: How large is the project? What is the contractor's experience on this type of project? What is his or her work on hand? The "three C's" -- a term well understood in surety underwriting -- include an assessment of the bond principal's capital, capacity and character. Construction bonds involve a much higher level of underwriting and risk analysis by the surety and premiums are priced accordingly. In some instances, where the contractor may be considered a higher-than-average risk, the surety may require collateral as a condition of issuing the bond.

Like the pre-issuance underwriting process described above, the surety's claims analysis similarly relies on risk assessment: What is the surety's exposure? What are its principal's defenses? Is there a prevailing party attorney fees provision in either the bond or the bonded contract? What is the principal's ability to satisfy its indemnity obligations to the surety? These and many other factors enable the surety to make an informed risk assessment decision in order to satisfy its obligations to the owner or the payment bond claimant.

Prior to Karton, a surety's exposure to attorney fees was understood to be capped by the penal sum of its bond -- and this was true of public works, private works and license bonds. See, e.g., Hartford Accident and Indemnity Co. v. Industrial Accident Comm., 216 Cal. 40 (1932) (known as "The Hartford Rule"); Harris v. Northwestern National Ins., 6 Cal. App. 4th 1061 (1992); T & R Painting v. St. Paul Fire & Marine, 23 Cal. App. 4th 738 (1994); Lawrence Tractor Co. v. Carlisle Ins. Co., 202 Cal. App. 3d 949, 956 (1988) (without a specific contractual provision, a surety cannot be liable for attorney fees "beyond the express limits of its undertaking.").

In reaching its decision, the Court of Appeal in Karton relied primarily on Code of Civ. Proc. Section 1029.8 and Pierce v. Western Surety Co., 207 Cal. App. 4th 83 (2012).

Code of Civil Procedure Section 1029.8 provides: "Any unlicensed person who causes injury or damage to another person as a result of providing goods or performing services for which a license is required ... shall be liable to the injured person for treble the amount of damages assessed in a civil action in any court having proper jurisdiction. The court may, in its discretion, award all costs and attorney's fees to the injured person if that person prevails in the action." (Emphasis added.)

Section 1029.8 had heretofore never been applied to a license bond or surety bond. First of all, the clear wording of Section 1029.8 makes it only applicable to unlicensed persons. Wesco is not an unlicensed person. Ironically, license bonds are only required of licensed contractors. License bonds are not given to unlicensed persons and the effect of the trial court's determination that Ari was unlicensed should have exonerated Wesco. Code of Civil Procedure Section 993.440.

Second, Wesco did not "provide goods or perform services" for Karton.

And third, Section 1029.8 is penal in nature so should have been strictly, not broadly, construed. Business and Professions Code Section 7099.7 provides: "No order for payment of a civil penalty shall be made against any bond required pursuant to sections 7071.5 to 7071.8.

Had Ari committed fraud in connection with the Karton remodel, Business and Professions Code Section 7116 would make Wesco liable for any damage caused thereby. Had the Legislature intended to expose Wesco to liability for its principal's fraudulent conduct beyond the penal limit of its bond, it could have done so, but wisely decided not to.

The court's reliance on Pierce ("The Pierce decision mandates victory for the Kartons against Wesco") is similarly misplaced. Pierce involved a $50,000 statutory motor vehicle retailer bond required for licensure of a motor vehicle dealer by the Song-Beverly Consumer Warranty Act. Vehicle Code Section 11700. The Pierce court affirmed Pierce's motion awarding him attorney fees "in an amount not to exceed the remaining balance on the bond." 207 Cal. App. 4th at 87. Pierce is hardly precedent for the holding in Karton.

If Karton is allowed to stand, it will open the floodgates for lawsuits against license bond sureties and their bond principals. Sureties, unwilling to risk exposure to attorney fees far greater than the penal limit of their bonds, will simply pay the claim, however unmeritorious, in order to avoid potentially unlimited exposure to attorney fees. At that point, the surety will demand that the contractor indemnify it under the terms of its indemnity agreement and Civil Code Section 2747. If the contractor doesn't have $15,000, the surety's loss is reported to the license board and the contractor's license is suspended until he or she makes good. This would be a terrible result for both sureties and contractors. But certainly it would make for a bonanza for bond claimants and homeowners. Moreover, the price of the bond premium will also skyrocket.

The portion of the case dealing with lawyer incivility as affecting attorney fees awards should stand (for more on that see Franklin Garfield's March 17 column, "Incivility ruling has implications for divorce litigators"). The portion imposing attorney fees on Wesco's license bond should be reversed or depublished. It is bad law and bad precedent. 