In order to gain some protection against paying for disputed or insufficient work, or from claims made by subcontractors and suppliers, public entities are allowed to withhold certain funds otherwise due to contractors. However, this ability to retain funds is strictly controlled and regulated by the state’s retainage laws, and works in conjunction with specific requirements for general prompt payment. In California, Public Contract Code 7107 authorizes and dictates the retention of these funds. If a public entities wrongfully retain funds from a contractor, they can be subject to penalties and fees. Recently, a major conflict over what constitutes a “dispute” has arose in California Appellate Courts.
Conflicting Cases – Trend Toward a More Fair Approach?
The Martin Brothers court determined that “[t]he statute contains no language restricting the word ‘dispute’ to any particular kind of disputeIn Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc. a California court of appeals allowed a contractor on a project to withhold funds from a subcontractor pursuant to Public Contract Code section 7107 – and based on a disagreement over whether or not payment was due for various change orders. The statutory language of the section at issue notes that retention of funds is allowed when a “bona fide dispute” exists between the parties. The Martin Brothers court determined that “[t]he statute contains no language restricting the word ‘dispute’ to any particular kind of dispute other than it must be ‘bona fide.’” The court further found that there was nothing in the provision to show a “legislative intent to limit the types of honest dispute that will justify the withholding of retentions.” While this is a clearly defensible interpretation of the statute at issue, it allows for money to be withheld in excess of the disputed amount, and so, could be disproportionately detrimental to the subcontractor – or the parties hired by the subcontractor. A different recent case provides what is likely a more fair approach.
In East West Bank v. Rio School District, a rehearing of a case previously discussed as a potential warning as to the significant potential penalties associated with California prompt pay laws, a California court of appeals examined a similar set of facts as did the court in Martin Brothers.
“[t]he purpose of a retention is to provide security against potential mechanics liens and to insure the contractor will complete the work properly and repair defects.In this case, however, the funds retained for a longer period than statutorily allowed pursuant to a dispute over change orders were held by a public entity, rather than a general contractor, and, a much different result was reached. As you may recall, in the original case, the court awarded the GC $9,356,124.81 in damages (an amount greater than the original contract price) for the balance due under the contract, extra work performed, delay and disruption caused by the school district, statutory penalties pursuant to section 7107, attorney fees, prejudgment interest and costs after a 10 year long legal battle and a 243-day long trial. In all aspects relevant to this discussion, the court affirmed the decision on re-hearing.
Rio School District, the public entity, contested that it was entitled to withhold the retention funds (10% of each progress payment) because of the dispute that existed between the two parties related to the amount due for multiple change orders, and relied upon Martin Brothers to support that contention. The court in East West Bank disagreed. The court examined the remedial purpose behind the statute at issue, and concluded that “[t]he purpose of a retention is to provide security against potential mechanics liens and to insure the contractor will complete the work properly and repair defects. The retained funds must be paid to the contractor when the security is no longer required.” In this case, the project had been completed, all stop notices had been released, and there was no additional threat for which the school district required the security of the retained funds.
The court stated that “[t]he purpose of section 7107 is to deter public entities from improperly withholding retention payments” and should therefore be construed in light of this purpose. In the words of the deciding court:
Section 7107’s purpose of ensuring the prompt release of retention funds would not be served if any dispute justified retaining the funds. There is no reason to allow a public entity to retain the funds once their purpose of providing security against mechanics liens and deficiencies in the contractor’s performance has been served. Unless the dispute relates to one of those purposes, the public entity will not be protected from the statutory penalty.
What Does This Mean?
The conflict between the courts may result in some difficulty in determining what particular type of “dispute” allows for the continued withholding of retained funds – but both public entities and GCs should exercise caution in retaining funds past the deadline for payment under the prompt pay laws. Indeed, as shown above, improperly withholding funds past the prompt pay deadlines can result in significant penalties.
However, as noted by the court in East West Bank, the purpose of retaining funds past the general deadline by which payment must be made is to “provide security against potential mechanics liens and to insure the contractor will complete the work properly and repair defects”. If this is not needed, and a dispute is unrelated it makes sense that the funds should be released. Hanging onto money that doesn’t have anything to do with the actual dispute at issue is not fair – and it may be severely penalized. The quick and easy solution, like so many things in life, is to be fair.