Short Answer:  No.

Long Answer:  This is a question we get a lot related to the California and Arizona preliminary notice requirements. Unfortunately, however, it’s all related to a misunderstanding of the “20% Rule.”  The first misunderstanding is that the rule applies to California and Arizona (it only applies in Arizona). The second misunderstanding is that it impacts the estimated contract amount that should be entered into your preliminary notice.

This post will explain the misunderstandings and help you properly prepare your California (or Arizona) preliminary notice.

Estimated Contract Amount Is Required In Your California or Arizona Preliminary Notices

Prior to discussing the “20% Rule” phenomenon it is important to understand the basic “estimated contract requirement.”  This requirement exists in both California and Arizona’s mechanics lien laws. It requires the party furnishing labor or materials to a project to disclose the “estimated contract value” within the preliminary notice document itself.

Many suppliers and subcontractors do not like this requirement because it requires them to send their contract amount to the prime contractor and/or the property owner. In many instances, their [the party giving notice] customer is putting a markup on the contract amount, and therefore, disclosing the actual contract amount can create some friction between all the parties. Nevertheless, an estimated contract amount is required or the preliminary notice is not valid.

Which brings us to the hardest question to answer: what is the “estimated” amount?  Especially when considering change orders, change directives, and suppliers who supply to projects on open accounts, pinpointing the actual amount for a contract can be tough.

Both Arizona and California’s laws simply require that the estimate be made in “good faith,” which means that you just shouldn’t be sneaky.

That’s the general background to the estimated contract value requirement in preliminary notices…but next comes some more specific information and rules which muddy the water and lead to the 20% misunderstanding.

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Arizona’s 20% Rule: The Two Common Misunderstandings

Editor’s Note: The number is 30%, rather than 20%, for jobs begun on or after December 31, 2019: Arizona’s 20% Rule Changes to 30% starting in December 2019.

To prevent folks from estimating the contract value in “bad faith” and abusing the purpose of the preliminary notice disclosure, Arizona passed what is known as the “20% Rule.”   We’ve written about the Arizona 20% Preliminary Notice Rule on the blog in the past, where you can find more detail.  Here we will explore two common misunderstandings.

The 20% Rule Does Not Allow or Require You To Add 20% To Your Estimated Contract Value

Editor’s Note: This threshold jumps from 20% to 30% on December 31, 2019. More on that here: Arizona’s Amended 20-Day Preliminary Notice Rule Changes in December.

The Arizona 20% Rule provides that if the actual furnishing or contract value exceeds the disclosed value in the preliminary notice by more than 20%, an additional preliminary notice will be required to disclose the additional furnishings.

Many people misinterpret this and add 20% to their good faith estimate of the contract value, but this results in the notice artificially exaggerating the value. This is not what the rule calls for, and in fact, could invalidate the notice.[/quote]In other words, the party providing preliminary notice must disclose the estimated contract value within the notice.  The disclosure must be made in good faith.  However, if the actual furnishing value exceeds the disclosed value by more than 20%, another preliminary notice will be required to notify the parties of this additional furnishing.  If the disclosed value is only exceeded by 19%, not additional notice is required.

Many people misinterpret this to think that they should take their good faith estimate of the contract value and add 20% to it at the time of sending the preliminary notice, so that the preliminary notice’s disclosed value is artificially exaggerated by 20%.  This is not what the rule calls for, and in fact, could invalidate your preliminary notice since it will not be a “good faith” estimate of the true value of the contract.

This misunderstanding is very prevalent in Arizona. I worked with a company in Arizona who was quite large and sent hundreds of notices per month. Since they were adding 20% to each one, there was a good argument to be made that each of those notices were invalid as the estimated amounts were not estimated.  Don’t take this risk!

The Arizona 20% Rule Does Not Apply In California

The basis for this misunderstanding — the Arizona rule — doesn’t even apply in California. This second misunderstanding about the Arizona 20% Rule is more surprising than the first, but perhaps even more popular. For whatever reason, companies on California frequently wonder whether they should be adding 20% to their California preliminary notices.  The answer is no, and is no for two reasons.

First, California preliminary notices require you to estimate the contract value in good faith, and artifically increasing it by 20% is a violation of this duty.  Just like in Arizona you should not increase the contract amount by anything. Just say what it is.

Second, the basis for this misunderstanding — the Arizona rule — doesn’t even apply in California.  It is strictly an Arizona rule and has no effect in California.

California Preliminary Notice: What To Do When Your Estimated Contract Value Is Wrong

Now that you know about the Arizona 20% Rule and the purpose of California’s preliminary notice statute requiring a good faith estimate of the contract price you may wonder how California handles the situation when the actual contract price far exceeds the value estimated within the preliminary notice. How wrong, in other words, can your estimate be?

The answer, unfortunately, is surprisingly gray. California statutes do not address the issue and California case law does not set any bright-line rules to guide claimants.

A best practice is to (i) Rely on the California statute and don’t worry about it if you don’t have to; but (ii) to also use common sense.

First, California law requires you to estimate the contract price. Technically, you can exceed this by 500x’s so long as the original estimate was in good faith, and the amount was exceeded within the same contract.  If you executed a second contract you need to send preliminary notice on the new contract.  A change order is not a new contract, it is simply a change to the existing contract, and therefore, an additional preliminary notice should not be required.

However, the second thing to do is use your common sense.  If your contract exceeds the estimated value by 60% or more, it may be worth just sending another notice to be safe.  It’s a best practice.  But if you don’t get around to it, see the above paragraph….you are probably pretty safe.

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