Is The Failure To Comply With A Change Order Notice Provision A Material Breach?

Division I of the Washington Court of Appeals recently sought to answer this question. It held that the failure of an owner and builders to comply with a written change order requirement did not materially violate a loan agreement. In Top Line Builders v. Bovenkamp, 179 Wn. App. 794, 320 P.3d 130 (2014) the property owner entered into a fixed-price contract with a builder to construct a custom residence. The owner secured a loan from his bank in an amount sufficient to cover the contract price with an allowance for potential cost overruns. The owner, builder and bank subsequently entered into a tri-party Loan Procedures Assignment and Consent Agreement (“LPA”) which mandated that any change orders resulting in cost overruns would be in writing and would be submitted to the Bank.

Over the course of construction the owner and builder agreed on a number of modifications to the construction plans—modifications which caused overruns. As you can guess, the owner and builder failed to execute the required change orders in violation of the LPA. Following completion of the home the builder moved to foreclose its lien for the balance of the unpaid contract price and overruns. The amount sought, however, did not exceed the total loan amount. The bank, a named defendant, sought to limit the builder’s recovery to the unpaid balance of the fixed price contract by arguing that the bank had no obligation to pay overruns because the change orders were never submitted.

The Court of Appeals ruled that the builder was entitled to the entire unpaid balance, including the amount owed under the change orders. The court held that the failure of the owner and builder to submit written change orders was a technical and immaterial breach of the LPA because “even if change orders were presented to [the bank], it had no right to object or require [the owner] to deposit additional funds.” In short, no harm no foul.

Although the court held that no material violation of the LPA occurred, this ruling should not be construed as an invitation to disregard the terms of your construction contracts. Had the change orders created overruns in excess of the total loan amount, the court likely would have found a material violation of the LPA.

The Court of Appeals Clarifies the Purpose of Public Contract Code § 7107 & the Ramifications for Public Entities Violating the Same

On April 1, 2015, in East West Bank v. Rio School District, the Second Appellate District of the California Court of Appeals held that whereas under Public Contract Code § 7107, a public entity can withhold funds owed to a contractor when there are liens on the property or when there is a good faith dispute concerning whether the work was properly performed, the public entity cannot withhold funds due to a contractor over a dispute over the contract price. In reaching its holding, the court noted its disagreement with Martin Brothers Construction, Inc. v. Thompson Pacific which held otherwise. The Court also held that the doctrine of “unclean hands” does not apply to Public Contract Code § 7107, to limit a contractor’s potential recovery of damages and attorney’s fees. Finally, the Court held that the time limitations for a contractor to submit a claim under a public works contract do not apply where that contractor’s claims arise out of the public entity’s alleged breach of that contract.

Background Facts

In East West Bank, the Rio School District (District) entered into a contract with FTR International, Inc. (FTR) to build a school. During construction, FTR submitted approximately 150 proposed change orders (PCOs), asserting that they were necessary due to the District providing plans that were inadequate and misleading. The District, however, denied most of the PCOs on the grounds that the work was covered under the base contract, that the amounts sought by FTR were excessive, and/or on the grounds that a given PCO was untimely in accordance with the public works contract notice provisions. The project was ultimately completed in June 2001 and the District filed a notice of completion on August 7, 2001.

Thereafter, a dispute between FTR and the District arose out of a payment issue. Under the contract, the District retained 10% of each progress payment, such that at the completion of all work, the District held a reserve of $676,436.49. The reserve was subject to stop notices filed by FTR’s subcontractors until the last stop notice was released on September 28, 2004. When the District failed to pay the balance due under the contract, refused to release any of the retention, and refused to compensate FTR for delay and disruption damages, FTR filed suit. FTR asserted a claim against the District for breach of contract and violation of Public Contract Code § 7107, seeking damages, statutory penalties, attorney’s fees, interest and costs. The District countered with a separate lawsuit, which was subsequently consolidated. After the trial court found in FTR’s favor, the District appealed, raising three primary issues regarding when a public entity can withhold retention payments under Public Contract Code § 7107, whether a contractor must comply with time limitations for filing a claim under a public works contract following a breach, and whether a public entity can assert an “unclean hands” defense to dispose of a claim for damage and attorney’s fees following a statutory violation.

Explanation of the Court’s Decision

In reaching its decision, the Second Appellate District noted that Public Contract Code § 7107(c) calls for a public entity to release any retention previously withheld within 60 days after completion of a work of improvement. In the event of a dispute, the public entity can withhold from the final payment an amount not to exceed 150% of the disputed amount. Under subsection (f), however, a public entity will be subject to a penalty of 2% per month, in lieu of interest, on any contract amount improperly withheld, plus attorney fees and costs. At trial, the District argued that it was justified in withholding the retention amount – more than 10 years after completion of the project – due a good faith dispute with FTR over whether a majority of the 150 PCOs were wrongfully denied, which the District claimed, impacted how much money, if any, it owed FTR. The Court, however, found that argument unavailing. It noted that the purpose of retention is to provide security against potential mechanics liens and to insure that the contractor will complete its scope of work properly and repair any defects. The Court added that once the public entity no longer needs that security, the retention funds must be paid. Since the dispute with FTR for additional monies did not require the District to retain funds as security, the District’s failure to pay is exactly the type of behavior that Public Contract Code § 7107 was enacted to deter. Thus, the Court found that the District was subject to the statutory penalty.

Next, the Second Appellate District in East West Bank addressed the issue of whether a contractor can recover damages on claims that are not submitted within the time limits set forth under a public works contract. On this issue, the Court found that some of FTR’s claims arose from the District’s breach of the contract, in not providing adequate plans and specifications. As a result, the Court – relying on a seldom-used 1959 decision in D.A. Parrish & Sons v. County Sanitation Dist., etc. — held that the time limitations in a public contract do not apply to claims arising from the public entity’s alleged breach of that contract.

The Second Appellate District in East West Bank concluded with a discussion regarding whether a public entity can assert an “unclean hands” defense to FTR’s claim for damages, penalties and attorney’s fees under Public Contract Code § 7107. Reviewing the purpose behind the code section, the Court noted that when the California Legislature enacts a statute forbidding certain conduct for the purpose of protecting one class of persons from the activities of another, a member of the protected class can maintain an action for a violation of that statute, notwithstanding the fact that the plaintiff shared in the illegal transaction. The Court added that the protective purpose of the legislation is only realized by allowing the plaintiff to maintain an action against the defendant within the class that is to be deterred.

In this instance, Public Contract Code § 7107 was intended to protect one class of persons (public works contractors) from the activities of public entities. As a result, the doctrine of “unclean hands” does not apply a matter of law, and FTR (as a member of the protected class) can recover attorney’s fees, in addition to all other damages available as a result of the District’s violation of the statute.

Takeaways

All told, the East West Bank case is good news for contractors on public works contracts. A public entity cannot withhold retention from contactors on projects involving a payment or contract dispute, in the absence of a mechanics lien, a stop notice, or a claim of defective work. Particularly where a payment dispute can take years to resolve through litigation, this case is a reminder that public entities cannot hold onto retention amounts as a means of placing economic pressure on the complaining contractor. Where the public entity engages in that behavior, it will may be liable to the contractor for damages, attorney’s fees and penalties under Public Contract Code § 7107. Moreover, the public entity will not be able to assert an “unclean hands” defense to reduce or eliminate an award in the contractor’s favor.

The East West Bank decision, however, also highlights a split of authority between the California Courts of Appeal regarding whether a contractor will have waived a claim for damages and extra compensation under the (typically) harsh notice provisions in public works contracts. In this instance the Court held that District’s breach of the contract disposed of the notice requirements, but in many instances, courts have would have foreclosed any recovery for FTR’s claims for extra compensation. Thus it is very important for contractors on public works projects to comply with the notice provisions – despite this recent decision — or else risk forfeiture.

For more information on the East West Bank case, navigating the potential perils of public works contracts and other developments in Construction Law, please feel free to contact the attorneys at Gordon & Rees LLP.