When to Withhold Retention Payments on Private or Public Projects

To ensure that construction contractors and subcontractors receive timely progress and retention payments, the California Legislature enacted statutes that impose deadlines and penalties on owners and direct (general) contractors who delay payments. (Cal. Civ. Code, §§ 8800, 8802, 8812, 8814; Pub. Contract Code, §§ 7107, 10262.5; Bus. & Prof. Code, § 7108.5.) However, there is an exception to these deadlines and penalties on both private and public projects. The exception allows an owner or direct contractor to withhold payment1 when there is a good faith dispute between an owner and a direct contractor or between a direct contractor and a subcontractor. (Civ. Code, §§ 8800, subd. (b), 8802, subd. (b), 8812, subd. (c), 8814, subd. (c); Pub. Contract Code, §§ 7107, subds. (c), (e), 10262.5, subd. (a); Bus. & Prof. Code, § 7108.5, subd. (a).)

But the term “good faith dispute” has been a source of confusion where direct contractors owe subcontractors retention payments, but want to withhold the payment because of a dispute.2 California appellate courts were split, with one court finding that any type of bona fide dispute justified withholding, and another finding that only disputes related to the payment itself justified withholding. (Compare Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc. (2009) 179 Cal.App.4th 1401 [any bona fide dispute could justify withholding] with East West Bank v. Rio School Dist. (2015) 235 Cal.App.4th 742 [disputes related to the payment itself may justify withholding].) In May 2018, the California Supreme Court clarified that for a direct contractor to withhold a retention payment on a private project, the good faith dispute must somehow relate to the payment itself. (United Riggers & Erectors, Inc. v. Coast Iron & Steel Co. (2018) 4 Cal.5th 1082, 1097-1098.)

In United Riggers, a direct contractor and subcontractor disputed the total amount owed to the subcontractor for a project. (United Riggers & Erectors, Inc. v. Coast Iron & Steel Co., supra, 4 Cal.5th at p. 1086.). The subcontractor demanded roughly $350,000 more than the amount authorized by the contract and approved change orders because the direct contractor allegedly mismanaged the project. (Ibid.) When the project owner eventually released the final retention amount, the direct contractor refused to provide the subcontractor with its share of the retention even though the retention payment itself was undisputed. (Ibid.) The subcontractor sued for the late retention payment and for mismanagement of the project. (Ibid.) At trial, the direct contractor prevailed on all claims. The appellate court, however, reversed on the issue of the late retention payment, and the Supreme Court affirmed. (Id. at pp. 1086-1087.)

Although the direct contractor admitted it did not timely pay the subcontractor the retention amount, it claimed that the “good faith dispute” exception under Civil Code section 8814 justified the delay. (United Riggers & Erectors, Inc. v. Coast Iron & Steel Co., supra, 4 Cal.5th at p. 1089.) Section 8814 requires that on private projects, direct contractors pay subcontractors retention payments within 10 days after receiving them from owners unless a good faith dispute exists between a direct contractor and a subcontractor. (Civ. Code, 8814, subds. (a), (c).) The direct contractor argued that because there had been an ongoing dispute about the direct contractor’s alleged mismanagement of the project and the total amount owed to the subcontractor when the direct contractor withheld the retention payment, the withholding had been justified. (United Riggers & Erectors, Inc. v. Coast Iron & Steel Co., supra, 4 Cal.5th at p. 1089.) The subcontractor responded that because the dispute about the direct contractor’s alleged mismanagement of the project and the total amount owed did not directly relate to the retention payment—an amount that was undisputed—the direct contractor had not been justified in withholding it. (See ibid.)

After comparing Section 8814 to other prompt payment statutes and analyzing the legislative history of those statutes, the Supreme Court concluded that Section 8814 permitted retention withholding only where disputes concerned the retention payments themselves. (Id. at pp. 1092-1093, 1097-1098.) The Supreme Court emphasized that this would further the purpose of the prompt payment statutes to ensure timely payment of undisputed amounts, without undercutting contractors’ rights to withhold disputed amounts. (Id. at p. 1097.) Thus, where direct contractors owe retention payments to subcontractors on private projects, direct contractors may withhold retention amounts only where there are good faith disputes relating to those particular payments. (Ibid.)

Notably, although the Supreme Court’s holding concerned Section 8814, which applies only to private projects, the Supreme Court’s holding and reasoning also likely apply where direct contractors owe subcontractors retention payments on public projects. First, the Supreme Court indicated that generally legislators can reasonably anticipate that courts will accord the prompt payment statutes with a common construction. (United Riggers & Erectors, Inc. v. Coast Iron & Steel Co., supra, 4 Cal.5th at p. 1090.) Moreover, the Supreme Court specifically overruled the appellate opinion Martin Brothers Construction, which held that Public Contract Code section 7107 allowed direct contractors to withhold retention proceeds from subcontractors on public projects for any kind of dispute, to the extent Martin Brothers Construction was inconsistent with United Riggers & Erectors. (Id. at pp. 1095-1098.) In doing so, the Supreme Court noted that the opposite twin to the Martin Brothers Construction case, East West Bank, which held that section 7107 did not permit withholding for any kind of dispute, rested upon sound reasoning. (Id. at p. 1096.) Thus, most likely, direct contractors must timely pay retention amounts to subcontractors in the absence of a good faith dispute regarding those particular retention amounts, regardless of whether a project is public or private. (See id. at pp. 1095-1098.)
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1 The statutes authorize an owner or direct contractor to withhold up to 150 percent of the amount in controversy.
2 Most of the prompt payment statutes clarify that a good faith dispute must involve a dispute over the specific payment due. But Civil Code section 8814, relating to retention payments from a direct contractor to subcontractor on a private project, and Public Contract Code section 7107, relating to retention payments from a direct contractor to subcontractor on a public project, do not contain express language limiting the good faith dispute to a dispute over the payment due.

It’s Time to Change the Way You Think About Case Complexity

There are few things that lawyers love more than telling war stories. Partially, that’s because many lawyers either only or primarily have friends who are lawyers, and war stories are a way for lawyers to relate to each other—your barber doesn’t understand the pain of reading through 5 paragraphs of irrelevant objections posed to each of 75 interrogatories, but your fellow lawyers will. One common feature of war stories is a note regarding how much was at issue in the case. “I was handling this $25 million claim once….” Lawyers include the dollar figure in dispute as a shorthand for the complexity of the case they’re talking about. “Oh, we’ll be in depositions for a month solid, this is a $10 million case!”

I don’t know where I picked up this habit, but I know exactly how I learned to rethink it. A friend of mine, as in-house counsel, was handling a case worth over a billion dollars. When he told me about it, my jaw dropped. One of the first things I asked him was, how do you manage a case that big? And he told me about the several law firms he had engaged, all the people working on it. But then he said: it’s not really a complicated case. There were only 4-5 real factual questions, and a similar number of legal ones. It’s just that every factual question had a very high price tag associated with it. The high price tag doesn’t make the factual question any more complex, or any harder to litigate. For example, your builders’ risk policy either has coverage for flood damage or it doesn’t. If it does, then it doesn’t matter whether the flood washed the whole building away or just some materials from the laydown area—coverage is coverage, irrespective of quantum.

I recently arbitrated a case where $20 million in claims hinged on the interpretation of a single clause in a single sentence in a 30+ page contract. The quantum of damages that hung on the resolution of the meaning of that clause did not affect how complicated it was to interpret that clause. And at the conclusion of the arbitration, the panel interpreted that clause to mean what most people off the street would have told you it meant. Put differently, the interpretation of that clause, and evidence that could be offered in aid of that interpretation, would have been exactly the same had the claim been $100,000, $1,000,000, or the $20 million actually claimed. The damages claim had no effect on the complexity posed by the interpretation of that sentence.

I do not mean to suggest that damages claims don’t pose their own problems. Sometimes (but not always), as damages claims grow, their formulation does become more complex, although seldom does the complexity increase linearly with the growth of the quantum. I do, however, mean to suggest that lawyers should shed our collective habit of using the claimed damages as a shorthand measurement for the complexity of the case. Sturdza v. United Arab Emirates, 281 F.3d 1287 (D.C. Cir. 2002) is an example of a highly complicated case where the eventual damages, had the plaintiff prevailed, would have amounted to the low six figures. In contrast, the lawsuit by developer Larry Silverstein (the owner of the World Trade Center buildings in New York) against his property insurers posed a simple question (did the Sept. 11, 2001 terrorist attack count as one or two occurrences under the applicable insurance policies), whose resolution was worth $3.55 billion. The $3.55 billion price tag did not make the insurance policies’ language any more convoluted, complicated, or harder to parse than the language would have been had the damages been only $35.5 million.

Even if you otherwise agree with me, you might well ask: okay, it’s a bad habit, but so what? What’s the harm? Ultimately, the answer is simple: the lawyer’s view of the complexity of the case colors every bit of advice he or she gives the client. How many document custodians to harvest ESI from. How many discovery motions to fight, and how hard to fight them. How many depositions to take. Lawyers have a related bad habit of using a certain percentage of the amount as issue (I’ve heard between 10% and 30%) as a “rule of thumb” for budgeting purposes, such that a $10 million case ought to have a legal fees and costs budget of between $1 and $3 million. As long as we keep using the damages claim as a shorthand for the complexity of the case, we’re going to continue to give clients bad advice—advice that is keyed to a level of complexity (high or low) that the case doesn’t actually have.

Rather than asking how much is at issue, lawyers (both in-house and outside) should ask: what factual or legal questions control the resolution of this case? How hard are those questions to answer? Where will the evidence that answers these questions be found? Don’t collect ESI from 20 custodians because it’s a $20,000,000 case; do collect ESI from 20 custodians if each of them is likely to possess information critical to the resolution of key factual questions. In short, stop making decisions based on the quantum of damages being sought, and start making them based on the issues that affect entitlement to those damages. When your strategy is guided by the factual complexity of the case, rather than the quantum of damages being sought, the solutions you craft for your clients will more accurately reflect what really needs to be done in the case.

Gordon & Rees to Present a One Day Legal Conference in New York City

On Jan. 22, Gordon & Rees will present a one day legal conference in New York City, addressing 10 different areas of law.  This first annual Gordon & Rees Legal Education Conference will go forward in downtown Manhattan, at the Convene Conference Center, 32 Old Slip, NY.  During the conference, Gordon & Rees construction attorneys Amy Darby, Ernie Isola, and Matt Hawk will present a one hour panel discussion entitled “Risky Business – Shifting the Risk in Construction Contracts.”  The panel will discuss risk shifting devices such as additional insured endorsements, defense and indemnity obligations, and limitation of liability clauses.  This program will focus on the effectiveness of those tools in light of emerging anti-indemnity statutes and new endorsements of general liability insurance. The panelists will discuss the newest trends and case law affecting these risk-shifting methods, how they are being applied and the practical implications of contractual and policy language. Using actual case studies and experience of the Gordon & Rees panelists, the program will provide an in-depth review of the challenges facing those seeking to shift the risk along with insight from the insurance industry regarding how additional insured policies are being interpreted. Finally, the program will deliver strategies for how to effectively shift the risk of liability on construction projects, as well as how to avoid pitfalls in the drafting of construction contracts.

Guests are invited to register for the full-day schedule or individual programs. The day will include a continental breakfast and lunch with keynote speakers Mercedes Colwin, managing partner of the firm’s New York office, and Wm. David Cornwell, Sr., a partner in our Atlanta office with the Sports, Media, and Entertainment Group.  The day will conclude with a hosted cocktail reception. Space is limited, so register today.

After Beacon: Use of Indemnity Provision in Conjunction With Limitation of Liability Clause

Design professionals in California have often used limitation of liability clauses as an effective risk transfer technique.  Given that a third-party plaintiff’s recovery is not capped by the limitation clause in a contract between the design professional and the developer, we have made it a practice to recommend to our clients that, in addition to the limitation, they attempt to negotiate an indemnity provision in which the owner indemnifies the design professional for any judgment in excess of the limitation of liability.

Even where developers are willing to agree to a limitation of liability provision, they often resist also including indemnification for any judgment in excess of the limitation of liability.   However, the July 3 Supreme Court of California ruling in Beacon Residential Community Assn. v. Skidmore, Owings & Merrill LLP highlights the purpose of an indemnity provision.

For the limitation to be truly effective, the indemnification agreement is necessary.  In the residential context, the developer is strictly liable for design errors.  Therefore an indemnification agreement only confirms that the developer will be responsible for the design exposure above the limitation of liability.

Design professionals should use the Beacon case as an opportunity to explore the risk transfer inherent in a limitation of liability with their clients and hopefully convince them of the appropriateness of using an indemnity provision in conjunction with a limitation of liability.

Gordon & Rees’s latest Construction Law Update

Check out Gordon & Rees’s latest Construction Law Update, our quarterly take on trends of interest to design professionals, contractors, and developers throughout the country.

In the most recent edition, members of the firm’s Construction Practice Group discuss commercial design professionals’ liability for faulty plans and inspections; whether insurance brokers owe a duty to procure coverage needed for a project; new developments related to SB 800; construction managers, licenses and disgorgement; and bonded stop notices as a tool to secure payment.

For even more essential analysis on the impact of legal changes in the industry, go to http://www.gordonrees.com/practices/construction.