Liability for Subcontractors’ Failure to Pay Laborers on Private Works: How to Protect your Company

05.17.2019

Last year, the California legislature enacted Labor Code § 218.7 (AB 1701), which holds direct contractors (i.e., those with a direct contractual relationship with an owner) liable for unpaid wages, benefits, or contributions that subcontractors owe to their workers on certain construction projects.  The statute also allows direct contractors to protect themselves by requiring subcontractors to furnish payroll records that would enable direct contractors to evaluate their compliance with wage and hour laws.  When the original statute took effect, Governor Jerry Brown signaled that legislators would follow up with clarifying legislation. 

That legislation has now been enacted.  On September 19, 2018, Governor Brown signed Assembly Bill 1565 (AB 1565), which amends Section 218.7 to clarify the scope of direct contractors’ liability and establish additional requirements that direct contractors must meet in order to avail themselves of the audit rights provided under that statute.  AB 1565 was designated as urgency legislation and took effect immediately upon the Governor’s signature.

Background

Section 218.7 created significant potential liability for direct contractors if their subcontractors failed to pay wages, fringe benefits, or other benefits to laborers.  The statute’s reach, which is unchanged in the amended version, extends to any construction contract “for the erection, construction, alteration, or repair of a building, structure, or other private work” in California that is entered into on or after January 1, 2018.  Thus, contractors on public works of improvement are not affected by Section 218.7. 

Direct contractors are now liable for the failure of a subcontractor at any tier to pay wage, fringe, or other benefit payments or contributions, including interest on those amounts.  The original version of the statute also provided that this liability was “in addition to existing obligations and remedies provided by law,” except for penalties or liquidated damages resulting from a subcontractor’s failure to pay wages and benefit payments. 

The statute limits the entities that can make a claim to the Labor Commissioner, a “third party owed fringe or other benefit payments or contributions on a wage claimant’s behalf” (i.e., a labor union), and a joint Labor-Management Cooperation Committee.  It is noteworthy that the statute does not confer any private right of action on individual employees.  Claimants have one year from the earliest of the following to file a lawsuit:  (1) the date on which a Notice of Completion of the project is recorded; (2) the date on which a Notice of Cessation of labor is recorded in connection with the project; or (3) the date on which work on the project is actually completed.

The original statute required subcontractors, upon request by the direct contractor, to provide itemized wage statements or other payroll records containing “information sufficient to apprise the requesting party of the subcontractors’ payment status in making fringe or other benefit payments or contributions.”  Upon request, subcontractors were also required to provide direct contractors with information about their lower‑tier subcontractors.  If a subcontractor failed to provide this information in a timely fashion, the direct contractor could withhold as “disputed” all sums owed to the subcontractor until the information is provided.

Changes Made by AB 1565

AB 1565 amends Section 218.7 in two notable ways.  First, the provision stating that direct contractors’ liability under the statute is “in addition to existing obligations and remedies provided by law” has been removed.  The statute has now been clarified to expressly limit contractors’ liability to wages and benefit payments, plus any interest due on those amounts.  The statute continues to state that direct contractors’ liability does not extend to liquidated damages or penalties that may be incurred by a subcontractor as a result of its failure to pay wages or benefits. 

More significantly, contractors seeking to protect themselves against the liability created by Section 218.7 must now ensure that specific audit provisions are included in their subcontracts.  As noted above, the original version of the statute required subcontractors to furnish payroll information “upon request.”  For any contract entered into on or after January 1, 2019, however, a contractor may not withhold payments as “disputed” for failing to provide this information unless the contract between the direct contractor and its subcontractor identifies the specific documents and information that the direct contractor will require a subcontractor to provide.

Subcontractors may include the same requirements in their contracts with lower‑tier subcontractors.  Both direct contractors and subcontractors may withhold as “disputed” all sums owed to a lower‑tier subcontractor until the specified information is provided, as long as that information was specifically required by that subcontractor’s contract.

What Can Contractors Do to Protect Themselves?

Contractors can take a number of steps to protect against liability under Section 218.7:

  1. Include broad defense and indemnity rights in subcontracts that include claims arising from the subcontractor’s failure to pay wages and benefits, and requiring subcontractors to defend the direct contractor against such claims.  Because the statute provides that direct contractors are not precluded from “establishing by contract or enforcing any otherwise lawful remedies against a subcontractor,” such indemnity agreements are not affected by Section 218.7.  Although indemnity and defense language will not completely erase the headache that Section 218.7 creates for contractors, it will greatly reduce their financial risk. 
  2. Require subcontractors of every tier to provide a payment bond or letter of credit.  A subcontractor’s inability or unwillingness to provide one of these may be an indication that a subcontractor is in financial distress or has had difficulties paying its laborers.  If a subcontractor is unable to provide a bond or letter of credit, consider requiring personal guarantees from the subcontractor’s owners, partners or key personnel for wage and benefit obligations.
  3. Prequalify and thoroughly vet subcontractors to ensure that they have a proven track record and are financially solvent.
  4. Include audit rights, withholding, and backcharge provisions in subcontracts requiring subcontractors to provide, with every application for payment, itemized wage statements or certified payroll reports for the period covered by the application.  Because claimants may argue that “wages” include premiums for non-compliant meal and rest periods, contractors may also want to require assurances that subcontractors have compliant meal and rest period policies and practices.  Subcontracts should clearly specify that failing to provide any required information will be a material breach of the subcontract and result in the withholding of all sums due (or a backcharge).  Subcontractors should include similar provisions in their lower-tier subcontracts.
  5. Monitor subcontractors’ compliance with wage and benefit obligations by requiring subcontractors to certify and submit evidence of their compliance as part of the approval process for every application for payment.  Although the subcontractor’s failure to provide the required records will not relieve a direct contractor from liability under Section 218.7, withholding the sums owed to that subcontractor will ensure that funds are available to satisfy any legitimate claims for unpaid wages or benefits.

Section 218.7 does not affect the direct contractor’s prompt payment obligations, including liability for prompt payment penalties.  Therefore, direct contractors should ensure that amounts not subject to a good faith dispute are paid within the required time.  Prompt payment penalties can accumulate quickly, so contractors should contact a construction attorney if there is any doubt about whether withholding is justified. 

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