California Appellate Court Apply The Objective Standard To Determine If There Is A Good Faith Dispute For The Purpose of Prompt Payment Statutes
William C. Last, Jr.
California has a number of statutes that allow contractors to recover prompt payment penalties when the other parties do not pay the amount due within certain time limits. If there is a good faith dispute the party who is disputing the claimed amount can withhold 150 percent of the disputed amount. The prompt payment statutes do not define the term "good faith dispute."
On April 25, 2011, a California Appellate Court rendered a decision in a case entitled FEI Enterprises, Inc. v Yoon that addressed what constitutes a good faith dispute. The FEI Court held that when determining a good faith dispute the critical question is whether or not the withholding party withheld the amount based on an objective standard rather than a subjective standard. A subjective standard is typically based on the withholding party's state of mind while an objective standard reviews all the facts and circumstances to determine if there was an objectively reasonable basis for withholding the funds.
In the FEI case, the owner of the project, Kee Man Yoon (Yoon), and general contractor, Pacific Construction Co. (Pacific Construction), refused to pay FEI Enterprises, Inc (FEI), the low-voltage electrical subcontractor. FEI sued Pacific for the amount due plus prompt payment penalties. Pacific filed a cross-complaint alleging that FEI breached the subcontracts. The trial court ruled that FEI did not breach the subcontracts because FEI had completed 90 to 100 percent of the rough installation that fell within its scope of work. In addition, FEI was excused from performing the remainder of the subcontracts' work because Yoon terminated FEI's contract. The court also ruled that FEI did not delay the projects because other trades were still performing their rough work after FEI finished. In addition, the court found that, although FEI had properly submitted its requests for payment to Pacific Construction, Pacific breached the subcontracts by failing to process FEI's properly submitted payment requests. Nonetheless the trial court denied FEI's request for prompt payment penalties based upon its finding that a good faith dispute existed as to the sums owed. The trial court interpreted a "good faith dispute" as being more like a "good faith belief."
The prompt payment statute that was reviewed by the FEI Court was Business and Profession Code section 7108.5 which requires a general contractor to pay its subcontractors their respective shares of a progress payment within 10 days of receiving that payment from the project's owner, unless the parties agree otherwise in writing. If the general contractor fails to timely pay, the subcontractor may recover a penalty fixed at two percent of the amount due per month for every month the payment is not made. However, a contractor may withhold progress payments from a subcontractor without exposure to the two percent penalty if there is a good faith dispute between the general contractor and the subcontractor over the amount owed.
The FEI Court stated: "The critical question should be the legal tenability of the justification for non-payment that was asserted. There simply is no reason to apply here the standards common to the state of mind, personal satisfaction or sole discretion cases. A legal dispute between two parties exists, is "legitimate," "genuine," "bona fide," or in "good faith" where the arguments asserted or positions taken have objective legal tenability. Nothing more should be required . " The objective standard has also been referred to as the "reasonable person test." The FEI Court then applied the objective standard and concluded there was a good faith dispute.
The remainder of this article will set forth a brief synopsis of the prompt payment statutes.
The Prompt Payment Statutes
A. PRIVATE WORKS: PROGRESS PAYMENTS DUE PRIME CONTRACTORS: Civ. Code §3260.1 requires owners to pay prime contractors within 30 days of contractor's request for payment on contracts entered into after 1/1/92. The penalty is assessed at 2% per month on the balance owed in lieu of interest. In the event that a lawsuit is filed to recover the balance owed, attorneys' fees and costs of collection are paid by the losing party. Back charges on the disputed work may not exceed 150% of the disputed amount.
B. PRIVATE WORK: RETENTION DUE PRIME CONTRACTORS: Civil Code §3260 requires owners to pay original contractors within 45 days after completion, and original contractors to pay subcontractors within 10 days of receipt of request for payment from owner. The statute defines "Date of Completion" as issuance of the certificate of occupancy or the date indicated on a valid notice of completion. (This does not apply to retention withheld by the lender pursuant to a construction loan agreement.) If the retention payment is designated by the owner to be paid to a particular subcontractor the amount should be paid to that subcontractor. Otherwise, the retention payment should be disbursed to the subcontractors who are owed money from that payment in amount equal to their share. This statute cannot be used by suppliers, laborers and/or equipment renters. The party who owes the funds can be subject to a penalty equal to 2% per month in lieu of interest, with attorneys' fees and costs of collection to be paid by the losing party. No more than 150% of the value of the disputed work may be withheld. Within ten days after the disputed work has been completed in accordance with the terms of the contract, the person withholding the disputed amount must notify the other party of the acceptance or rejection of the disputed work. If the disputed work is accepted, the person withholding the funds must release the withheld amount.
C. PRIVATE & PUBLIC WORK: PROGRESS PAYMENTS DUE SUBCONTRACTORS: Business and Professional Code §7108.5 and Public Contract Code §10262.5 require that any prime contractor or subcontractor pay all tiers of subcontractors within 10 days of receipt of funds by contractors. Violation entitles the subcontractor to an amount equal to 2% per month on the balance owed. In the event of a lawsuit, the prevailing party is entitled to attorneys' fees and costs. Back charge for disputed work is limited to 150% of amount disputed in good faith.
D. PUBLIC WORKS (State of California & State Universities): PROGRESS PAYMENTS DUE PRIME CONTRACTORS: Public Contract Code §10261.5 requires that state agencies pay the prime contractors within thirty days after payment request or engineer submittal. Public Contract Code §10853 requires state universities to pay prime contractors within thirty-nine days of the payment request. The penalty is assessed, on the balance, at 10% per annum on the balance owed. The statutes do not require payment of the contractor's attorney's fees. Although a back charge limit on the disputed work may be inferred from the duty of good faith, there is no express back charge limit.
E. PUBLIC WORKS ( Local Government Agencies) : PROGRESS PAYMENTS DUE PRIME CONTRACTORS: Public Contract Code §20104.50 requires that local government agencies pay contractors no more than thirty days after receipt of contractor's request for payment. The penalty is assessed, on the balance, owed at 10% per annum. The statute does not provide for the recovery of attorney's fees. Although a back charge limit may be inferred from the duty of good faith, there is no express back charge limit.
F. PUBLIC WORKS ( State or Local Agency): PROGRESS AND RETENTION PAYMENTS DUE DESIGN PROFESSIONALS: Civil Code §3320 requires that any public entity pay design professionals within thirty days of their demand if it is progress payment, and within forty-five days if retention is due. Civil Code §3321 requires that a design professional must pay both progress and retention payments to its sub-consultants within fifteen days after receipt from the public agency. A penalty of 1½ % per month in lieu of interest plus attorneys' accrue to the prevailing party. Back charge is limited to no more than 150% of disputed amount.
G. PUBLIC WORKS; RETENTION DUE PRIME AND SUBCONTRACTORS: Public Contract Code §7107 provides that any public entity must pay original contractor within sixty days after the date of completion, and that any original contractor must pay subcontractors within 7 days from their receipt of funds from any public entity. The penalty for failing to comply with the statutes is the assessment of 2% per month on the balance owed in lieu of interest. In the event a lawsuit is filed, the prevailing party is entitled to attorneys' fees and costs. Back charges are limited to no more than 150% of disputed amount.
The Prompt Payment statutes are valuable collection tools. However, the effectiveness of the statutes are, at times, limited by the right of the paying party to withhold sums if there is a dispute between the parties. It is common practice of owners and prime contractors to withhold funds from the other party to prod that party into completing the disputed work. However, some owners and prime contractors create baseless disputes to avoid paying balances legitimately owed. In that event, the party demanding payment should notify the non-paying party, in writing, when the disputed work is completed. Such a notice maybe the basis for a later court determination that the continued withholding of the funds was not undertaken in good faith.
While the prompt payment statutes may ultimately require you to institute legal action to recover the penalties, they are significant threats to non-paying parties. It is a good practice to recite the appropriate statute in any letter that demands payment of past due amounts. In the event, the contract does not provide for the payment of attorney's fees the prompt payment statutes may allow the prevailing party to recover that collection expense. The threat of a 2% penalty and attorney's fees may be sufficient to convince a non-paying party to pay the amount owed.
This article, ©2011, was written by William C. Last, Jr. and Fred Northrop. Mr. Last is an attorney who has been specializing in Construction Law for over 30 years.. In addition to belonging to a number of construction trade associations, Mr. Last holds a California "A" and "B" license. He can be contacted at 415-764-1990 or 650-696-8350. A number of his past articles can be found on his website (lhfconstructlaw.com). This bulletin is published periodically to provide general information about current legal issues. The articles are not intended to be a substitute for the advice of an attorney as to a specific problem. If you have a specific legal question or need legal advice, you should contact an attorney.