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(Reprinted
from the January 1999 issue of the Associated General Contractors
of California's Legal Briefs)
ConstructionWebLinks.com
Payment
issues on construction projects in California are becoming increasingly
complex and regulated. In the early 1990s numerous "prompt
payment" statutes were enacted and amended, and in 1998 changes
were made to these statutory schemes. Recently California
courts have clarified that "pay if paid" clauses are unenforceable.
Finally, effective January 1999, new legislation allows unpaid
contractors to suspend work without liability under certain conditions.
In responding to these developments, general contractors must
undertake careful planning and risk management in order to avoid
the "land mines" of owner insolvency and prompt payment penalties.
Simultaneously, contractors should exercise their statutory payment
rights to pressure owners to release timely payments.
This article will highlight some important aspects of the "pay
if paid" dilemma, review recent legislation (both successful and
unsuccessful) initiated in response to the "pay if paid" decisions
and, finally, organize and summarize the current prompt payment
legislation in California.
1. "Pay If Paid"
In 1997 the California Supreme Court declared that true "pay
if paid" clauses in subcontracts on private works of improvement
are unenforceable. Wm. R.Clarke Corporation v. Safeco
Insurance Company of America (1997) 15 Cal. 4th 882.
The court found that "pay if paid" clauses result in an "impermissible
indirect waiver or forfeiture of the subcontractor's constitutionally
protected mechanic's lien rights in the event of nonpayment by
the owner."
Clarke was quickly followed by a California Court
of Appeal decision that applied the rule to public projects.
Capitol Steel Fabricators, Inc. v. Mega Construction Co., Inc.
(1997) 58 Cal. App. 4th 1049. The facts of that case were somewhat
unusual. The general contractor, Mega Construction Co.,
Inc., had settled with the owner, the Long Beach Unified School
District. Before receiving the settlement proceeds from
the owner, Mega had paid its subcontractor, Capitol Steel Fabricators,
Inc., the entire principal amount of its claim. The subcontractor's
claim included $11,000 in extra work claims the contractor
had attempted to pass through to the owner.
Capitol Steel's remaining claims involved attorney's fees and
interest for the three-year period of nonpayment. The court
initially found that the subcontract contained a true "pay if
paid" clause pursuant to which "[i]f Mega, the general contractor,
were never paid, Capitol would be uncompensated." The court
concluded that a "general contractor's liability to its subcontractor
for work performed on a public works project may not be made contingent
on the governmental entity's payment to the general contractor
in a factual scenario such as is present in this case."
California law now appears to place considerable risk of owner
insolvency on general contractors on both private and public projects.
The general contractor may have to make payment to the subcontractors
regardless of whether payment is ever received from the owner.
These decisions leave many important questions unresolved.
For example, neither decision discussed whether a "pay if paid"
clause could be relied upon to justify a mere delay in payment
in a case where it appeared that the general contractor might
eventually receive payment or the extent to which a subcontractor
might be required to participate in a claims prosecution process
before receipt of payment.
2. Steps to Address the "Pay If Paid" Dilemma
These decisions are an obvious wakeup call for general contractors.
It is not prudent to undertake a private project relying solely
on mechanic's lien rights to secure payment. General contractors
should take additional steps to reduce the risks of owner insolvency
and also will need to revise the payment terms in their subcontract
and purchase order forms. Some relief also is occurring
through remedial legislation.
| a.
| Reducing the Risks of Owner Insolvency |
Owner insolvency will continue to be an issue primarily
on private projects. Many methods exist for reducing the
risks of private owner insolvency. The specific methods
employed will depend on the nature of the project and the bargaining
power of the parties.
In addition to conducting research into the financial resources
of the owner, a contractor can request that the owner to provide
security in the form of a standby letter of credit or bond. Certainly
any general contractor that is asked to post a payment bond may
respond by requesting an owner of questionable financial resources
to also provide security.
Contractors should consider the following contractual provisions
to obtain added protection from owner insolvency:
- Payment to the contractor of a substantial advance payment
that is proportionally reduced with subsequent payments.
An owner may obtain security by the contractor's provision of
a bond to secure the advance payment.
- Disburse all or a portion of the construction loan funds through
use of an escrow account.
- Give the contractor the right to suspend work within a brief
period of time after the event of nonpayment.
- Require the owner to provide evidence of its ability to finance
the work before start of work and periodically thereafter.
Specific provisions may be included allowing the contractor
to contact the construction lender and for the lender to provide
specified information to the contractor.
b.
Subcontract Terms
Many contractors have revised their subcontract forms
to delete the more obvious "pay if paid" provisions. However,
these subcontract forms should be thoroughly reviewed, as many
subcontracts also contain "pay if paid" language in their clauses
on changes, extra work and claims. Furthermore, purchase
order forms should also be reviewed and modified, as the logic
of the Clarke and Capitol Steel decisions applies
with equal force to direct suppliers of material and equipment.
The Capitol Steel decision suggests that "passthrough"
clauses for extra work claims by subcontractors also may be unenforceable
when the owner is insolvent. Capitol Steel involved
subcontractor claims for extra work that the contractor asserted
were the owner's responsibility. In invalidating the "pay
if paid" clauses, the court did not distinguish between the extra
work claims and other claims.
Subcontractors surely will rely on Clarke to argue that
"pay if paid" pass through/extra work clauses are unenforceable.
Certainly one interpretation of Clarke could be to invalidate
any subcontract language that would impair a subcontractor's mechanic's
lien rights or reduce the value of the lien.
Subcontractors may even rely on these decisions to attempt to
invalidate "no pay for delay" clauses, which provide that in the
event of owner-caused delays, the subcontractor's sole remedy is
an extension of time.
General contractors should attempt to include provisions in their
subcontracts and purchase orders that at least delay payment until
the contractor has taken all reasonable steps to procure payment
from the owner. The AGCC has already included the following
language in a 1998 revision to Form AGCC3, Long Form Standard
Subcontract:
"If owner or other responsible party delays in making any payment
to Contractor from which payment to Subcontractor is to be made,
Contractor and its sureties shall have a reasonable time to make
payment to Subcontractor. "Reasonable time" shall be determined
according to the relevant circumstances, but in no event shall
be less than the time Contractor, Contractor's sureties, and Subcontractor
require to pursue to conclusion their legal remedies against Owner
or other responsible party to obtain payment, including (but not
limited to) mechanic's lien remedies."
Contractors also may wish to consider including subcontract language
that requires the subcontractors to cooperate with the contractor
in all steps taken to prosecute subcontractor's claim against
the owner and that binds the subcontractor to the outcome of such
proceedings.
c.
1998 Remedial Legislation
Partially in response to the Clarke decision,
in 1998 two bills were introduced in the California Legislature.
Assembly Bill 2280 required private property owners who enter
into construction contracts for more than $1 million to provide
the general contractor with financial security. The security
could be in the form of a surety bond equal to 50 percent
of the contract, a letter of credit for 15 percent of the
contract or a cash deposit equal to three months of payments under
the contract. This bill was passed by the Assembly and the
Senate, but was vetoed by Governor Wilson.
Assembly Bill 2627 was passed and approved by Governor Wilson
in September 1998, and was adopted as Civil Code §3260.2.
This statute gives a contractor and its subcontractors the right
to suspend work when an owner fails to make payment within 35
days from the date the payment is due, provided that "there is
no dispute as to the satisfactory performance" of the contractor.
There are several detailed procedural requirements, including
the posting of a "10 day stop work order" and service of same
on the owner, subcontractors and the construction lender.
The statute only applies to contracts entered on or after January
1, 1999.
If the requirements of §3260.2 are followed, neither the original
contractor nor its direct subcontractors are "liable for any delays
or damages that the owner or contractor may suffer as a result"
of the stoppage of work.
In practice, the suspension of work provision of §3260.2 probably
will afford little relief for contractors as it will be extremely
difficult to prove that "there is no dispute as to the satisfactory
performance" of the contractor. There are almost always
some disputes between an owner and a contractor, and under
the statute it appears that any dispute about the contractor's
performance is enough to prevent the contractor from relying on
the statute to suspend work.
A potentially overlooked aspect of the statute provides that a
contractor who has served a "10 day stop work notice" and has
not been paid may, at the expiration of the 10 days, "seek a judicial
determination of liability for the amount not paid for work performed
in an expedited proceeding in the superior court." The statute
does not state that the contractor actually must stop work in
order to file the expedited action. Thus, §3260.2 may in
effect provide a new procedural tool for unpaid contractors to
use to accelerate payment of undisputed sums.
The availability of such a procedure may be seen as a balancing
of the rights of contractors and owners. Property owners
have the right to expedited court procedures to test the validity
of a contractor's mechanic's lien. See Connolly
Development, Inc. v. Superior Court (1976) 17 Cal. 3d 803;
Lambert v. Superior Court (1991) 228 Cal. App. 3d 383.
Now contractors may have a procedural right to seek an expedited
release of funds that would otherwise be the subject of a mechanic's
lien.
3. Summary of Prompt Payment Statutes
In 1990 there were only two statutes that expressly addressed
the issue of the release of funds on construction projects:
Business and Professions Code §7108.5 and Public Contract Code
§10262. These statutes essentially required a prime contractor
to pay a subcontractor the subcontractor's portion of any progress
payment within 10 days after receipt of the progress payment.
Failure to do so was grounds for disciplinary action by the Contractor's
State License Board.
In 1990 and 1991 Business and Professions Code §7108.5 was radically
amended, and several new statutes were added. The current
statutory scheme applies to both progress and retention payments
and to owners, prime contractors and subcontractors. Severe
interest penalties (2 percent a month) apply, and there are
provisions requiring the party violating the statute to pay the
other side's attorney fees. In some cases, the terms of
the statute can be varied by contract, and in others they cannot.
The primary "prompt payment" statutes and their areas of application
are as follows:
- Business and Professions Code §7108.5: Progress payments
to subcontractors on all private and some public projects
- Public Contract Code §10261.5: Progress payments to
contractors on some public projects
- Public Contract Code §§10262 and 10262.5: Progress payments
to subcontractors on some public projects
- Civil Code §§3260 and 3260.1: Retention payments to
contractors and subcontractors on private projects
- Public Contract Code §§7107 and 7200: Retention payments
to contractors and subcontractors on all public projects
The
accompanying chart has been prepared in order to summarize and
simplify the statutory requirements and penalties. Special
attention should be paid to whether the statutory requirements
can be modified. For example, a general contractor may wish
to specify that payments to subcontractors will be made 30 days
after contractor's receipt of payment. This is permissible
on both public and private projects but only for progress payments,
not retention.
The statutes all either refer to release of "undisputed" amounts
or allow for withholding of "disputed" amounts. Civil Code
§3260 is unique in that it provides a procedure for contractors
and subcontractors to be paid the "disputed" amount. Within
10 days of written notice "that any work in dispute has been completed
in accordance with the terms of the contract" the work must be
accepted or rejected, and payment must be made within 10 days
following acceptance.
The owner is required to release the retention proceeds within
specified periods after "completion." The definition of
"completion" in the operative statutes is similar but not identical.
The contractor is required to release the subcontractor's portion
of the progress and retention payments within a specified period
following contractor's receipt.
Finally, in 1998 legislation was enacted that modified some of
the payment rules on public projects. The time period for
the contractor's release of retention was reduced from 10 days
to 7 days (Public Contract Code §7107) and, for subcontracts entered
into after January 1, 1999, the percentage of retention proceeds
withheld from the subcontractor may not exceed the percentage
withheld from the prime contractor (Public Contract Code §7200).
CALIFORNIA PROMPT PAYMENT SUMMARY:
PRIVATE PROJECTS
A. Progress Payments
By Owner to Contractor
(Civil Code §3260.1)
Time: 30 days (contract may vary)
Dispute: 150 percent withholding maximum
Late payments:
- Penalty: 2 percent a month
- Collection action: attorney fees, costs
Payment to Subcontractors
(Business and Professions Code §7108.5; Civil Code §3260.1)
Time: 10 days (subcontract may vary)
Dispute: 150 percent withholding maximum
Late payments:
- Penalty: 2 percent a month
- Possible disciplinary action
- Collection action: attorney fees, costs
B. Retention Payments
Release by Owner
(Civil Code §3260)
Time: 45 days (contract may not vary)
Dispute: 150 percent withholding maximum
Late payments:
- Penalty: 2 percent a month
- Collection action: attorney fees, costs
Payment to Subcontractors
(Civil Code §3260)
Time: 10 days (subcontract may not vary)
Dispute: 150 percent withholding maximum
Late payments:
- Penalty: 2 percent a month
- Collection action: attorney fees, costs
PUBLIC PROJECTS
A. Progress Payments
By Owner Agency to Contractor
(Public Contract Code §10261.5)
Time: 30 days (contract may not vary)
Late payments: 10 percent per year penalty
Payment to Subcontractors
(Public Contract Code §§10262 and 10262.5; Business and
Professions Code §7108.5)
Time: 10 days (subcontract may vary)
Dispute: 150 percent maximum withholding
Late payments:
- Penalty: 2 percent a month
- Possible disciplinary action
- Collection action: attorney fees, costs
B. Retention Payments
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