California Supreme Court Clarifies Scope of "Good Faith Dispute" Exception to Prompt Payment Statutes
Timely payments are essential to enable general contractors and subcontractors to maintain an adequate cash flow and make payments to their subcontractors, suppliers, and laborers. To facilitate prompt payment on both private and public works of improvement, the Legislature has established statutory payment deadlines and imposed penalties on owners who delay paying their direct contractors, and on direct contractors who delay paying their subcontractors. These “prompt payment” statutes impose deadlines for both progress and retention payments from owners to direct contractors and from direct contractors to subcontractors. The most significant and often litigated of these deadlines are as follows:
- For both public and private works of improvement, an owner must make progress payments to a direct contractor within 30 days after receipt of an undisputed application for payment. In turn, the direct contractor must generally pay its subcontractors (and subcontractors must pay their lower-tier subcontractors) within 7 days after receiving a progress payment.
- On public works, an owner must release all undisputed portions of the retention to a direct contractor within 60 days after completion of the work. A direct contractor must pay its subcontractors within 7 days after receiving all or any portion of the retention, unless the retention received is specifically designated for a particular subcontractor.
- On private works, the owner must release all undisputed portions of the retention to the direct contractor within 45 days after the date of completion. If the direct contractor has withheld retention from subcontractors, the direct contractor must pay its subcontractors within 10 days after receiving all or a portion of the retention, unless the retention received is specifically designated for a particular subcontractor.
The deadlines above are enforced by monetary penalties of two percent per month of the unpaid amount, and by fee-shifting provisions requiring an owner or direct contractor to pay the attorneys’ fees of a direct contractor or subcontractor, respectively, who successfully sues to enforce the prompt payment statutes. In some cases, a contractor’s license can also be subject to disciplinary action for failure to make timely payments. However, the prompt payment statutes include an exception to these deadlines, authorizing owners and direct contractors to withhold up to 150% of the value of a “good faith dispute” between the parties. But the statutes are silent as to the kinds of “good faith disputes” that permit the withholding of progress payment and retention proceeds. Will any dispute between an owner and a direct contractor, or between a direct contractor and its subcontractor, permit the withholding of progress payment or retention proceeds, or must the dispute be related to the payment that would otherwise be due?
This question has led to a great deal of confusion—and litigation—regarding the effect of individual disputes on owners’ and general contractors’ prompt payment obligations. Owners and contractors were not alone in their confusion. Over the last decade, a split of authority has developed on this question among the Courts of Appeal. In 2009, the Third District Court of Appeal held that Public Contract Code § 7107, one of California’s prompt payment statutes, authorized the withholding of retention for any good faith dispute or controversy, regardless of the nature or subject matter. Taking the opposite position, the Second District Court of Appeal concluded in East West Bank v. Rio School District that only disputes related to retention’s security function can justify withholding.
In an earlier alert published shortly after the East West Bank decision, we observed that the Second District had created a split of authority among California’s appellate courts, and that the California Supreme Court would likely be called upon to resolve the appellate courts’ conflicting interpretations of California law. This occurred on May 14, 2018, with the California Supreme Court’s decision in United Riggers & Erectors, Inc. v. Coast Iron & Steel Co.
The facts of the United Riggers case were straightforward. Universal City Studios LLP (“Universal”), which owns and operates Universal Studios Hollywood, entered into a construction agreement with Coast Iron & Steel (“Coast”) for the design and installation of the metal work on its Transformers: The Ride attraction. Coast subcontracted the installation of the metal work to United Riggers & Erectors, Inc. (“United Riggers”) for a lump sum subcontract price. After completing the work to Coast’s satisfaction, United Riggers sought additional compensation arising from Coast’s alleged mismanagement of the project and disputed change order work. Coast refused payment and withheld nearly $150,000 in retention from United Riggers, citing the dispute over United Riggers’ claim for additional compensation.
United Riggers sued Coast in 2013, asserting a number of claims that included a statutory claim for prompt payment penalties. The trial court found that Coast was justified in withholding retention, relying on the dispute regarding additional compensation. In keeping with its earlier decision in East West Bank, the Second District reversed the trial court on the prompt payment claim, holding that retention could only be withheld for disputes that were directly related to the payment that would otherwise be due. Thus, the Second District reasoned that Coast could not use the parties’ dispute over project mismanagement and change order work to justify withholding United Riggers’ retention.
Facing a growing split of authority, the Supreme Court granted review to clarify “whether the Legislature’s prompt payment statutes should be interpreted to permit withholding where there is any dispute between a contractor and subcontractor, or only when there is a dispute regarding entitlement to the retention monies themselves.” Relying on the absence of any explicit limitation on the types of qualifying disputes in the prompt payment statutes, Coast argued that the Legislature intended to permit withholding of retention for any dispute, rather than only disputes concerning entitlement to the retention payment. United Riggers countered that the prompt payment statutes implicitly allowed the withholding of retention only when the good faith dispute related to that particular payment.
The Supreme Court agreed with United Riggers and held that prompt payment is excused only when the payor has a good faith basis for contesting the payee’s right to receive the specific monies that are withheld. Undertaking a comprehensive analysis of the statutory language, as well as the legislative history underlying the prompt payment statutes, the Court noted that the purpose of retention is to provide security against potential stop payment notices and to ensure that the contractor will complete its work properly and in accordance with the contract documents. The Court found that allowing the withholding of retention for reasons that are not related to these goals would defeat the purpose of the prompt payment statutes, which is to deter owners and direct contractors from withholding payment to direct contractors and subcontractors, respectively, as a means of granting themselves “interest-free loans.” Because disputes over mismanagement and change order work were not related to the work underlying the retention payment, such disputes could not justify the withholding of retention beyond the time limits specified in the prompt payment statutes.
Although United Riggers arose in the context of a contractor’s withholding of retention on a private work of improvement, the Supreme Court made it clear that its reasoning applied equally to other prompt payment statutes. Because the prompt payment statutes are all intended to accomplish a similar purpose (i.e., ensuring timely payment to contractors and subcontractors) and were closely related in context and statutory language, the Court explained that they should and would be interpreted similarly.
The Supreme Court’s decision resolves a decade-old split of authority among California’s appellate courts and has finally provided clarity to a heavily-litigated area of construction law. As succinctly stated by the Supreme Court, “the payor must be able to present a good faith argument for why all or a part of the withheld monies themselves are no longer due” in order to avoid prompt payment penalties. Owners and contractors should withhold retention and progress payments only when the sufficiency of performance is the subject of a good faith dispute, when liens or stop notices have been filed, or when payment would cause the payee contractor or subcontractor to receive more than the minimum amount both sides agree is due.
For other disputes, such as those concerning extra work, change orders, or schedule-related impacts that are not the subject of a lien claim or stop notice, owners and contractors should ensure that progress payments and retention are released within the time periods prescribed by the prompt payment statutes. Prompt payment penalties accumulate quickly and can even rival the principal disputed amount in some cases. Therefore, if there is any question as to whether a dispute is sufficiently related to retention or a progress payment, owners and contractors should consult with a qualified construction attorney before withholding payment.