In California, the payment of contractors is governed by so-called "prompt payment statutes" which are sprinkled through various legislative codes, and which impose sanctions on the paying party for non-compliance. Progress payments by general contractors to their subcontractors on private and most public works of improvement are governed by section 7108.5 of the Business & Professions Code. Retention payments to subcontractors on public works of improvement are governed by section 7107 of the Public Contracts Code, and on private works of improvement by section 3260 of the Civil Code. In some cases the statutes permit withholding of payments only where there is a "good faith" dispute. But what constitutes "good faith"?
All of these statutes provide that monies must be released to
subcontractors within a certain time except under special
circumstances, i.e., where a dispute is involved or where the
parties agree to an alternative payment scheme. Thus, where there
is a "good faith dispute over all or any portion of
the amount due on a progress payment," the general may
withhold up to 150 percent of the disputed amount. Bus. & Prof.
Code § 7108.5(c) (emphasis supplied). On a public project,
"if a bona fide dispute exists between the
subcontractor and the original contractor" the latter may
withhold from retention up to 150 percent of the estimated value of
the disputed amount. Cal. Pub. Cont. Code § 7107(e) (emphasis
supplied). And on a private project, if "a bona fide
dispute exists between a subcontractor and the original
contractor, the original contractor may withhold from that
subcontractor with whom the dispute exists its portion of the
retention proceeds . . . [not to] exceed 150 percent of the
estimated value of the disputed amount." Cal. Civ. Code §
3260(e) (emphasis supplied). Hence, a key factor as to when monies
may be withheld from a subcontractor without exposing the general
contractor to sanctions is whether there is a bona fide or
good faith dispute between the parties.
The case of Alpha Mechanical, Heating & Air Conditioning,
Inc. v. Travelers Casualty & Surety Company of America, 133
Cal. App. 4th 1319 (4th Dist. 2005) was the first to expressly
examine what constitutes a "good faith dispute" on a
private work of improvement under Bus. & Prof. Code §
7108.5 and Civ. Code 3260. In that case, the court observed that
"the phrase 'good faith' does have a distinct meaning
and purpose in the law" (id., at 1339) and
"suggests a moral quality; its absence is equated with
dishonesty, deceit or unfaithfulness to duty," Guntert v.
City of Stockton, 43 Cal. App. 3d. 203, 211 (1974) (citation
omitted), or "that state of mind denoting honesty of purpose,
freedom from intention to defraud, and, generally speaking, means
being faithful to one's duty or obligation." People v.
Nunn, 46 Cal. 2d 460, 468 (1956). The court noted the comments
of another authority: "Good faith, or its absence, involves a
factual inquiry into the plaintiff's subjective state of mind.
[Citations] Did he or she believe the action was valid? What was
his or her intent or purpose in pursuing it?" Knight v.
City of Capitola, 4 Cal. App. 4th 918, 932 (1992).
In Alpha Mechanical, the general contractor did not make
final payment because it alleged that the subcontractor did not
correct work deemed defective by the owner and damaged the work of
other trades - necessitating repair work for which the general
would have to pay if the subcontractor did not. The appellate court
found no evidence in the record suggesting that the general
contractor "lack[ed] good faith in its belief that the dispute
over the damage caused by Alpha justified withholding the remaining
sums due it." Id., 133 Cal. App. 4th at 1340. Hence,
the general contractor was not subject to penalties under either
Bus. & Prof. Code § 7108.5 or Civ. Code 3260.
Alpha Mechanical involved a classic dispute over work
performed under the contract. However, no such dispute was involved
in the more recent case of Martin Brothers Construction, Inc. v.
Thompson Pacific Construction, Inc., 179 Cal. App. 4th 1401 (3d
Dist. 2009), involving a public work of improvement. Martin
Brothers involved a dispute over changed work, specifically
over additional compensation that the subcontractor contended was
owed over and above the agreed contract price for work that was
allegedly outside the scope of the contract. The subcontractor
sought to recover penalties under Public Contract Code section 7107
for the general's failure to release retention. The appellate
court in Martin Brothers held that the reference to
"dispute" in section 7107 encompassed any
dispute, so long as the dispute was bona fide. Hence, even
though there was no dispute over the amount of retention owed under
the contract, the court found the general was justified in
withholding retention while the change order dispute was
pending.1 The court's holding in Martin
Brothers was surprising to many observers because it allowed
the general contractor to withhold undisputed sums solely due to a
dispute over whether additional sums were owed. Alpha
Mechanical and Martin Brothers constitute a very broad
reading of what can constitute a bona fide dispute and
suggest that nearly any dispute, so long as it is
genuinely believed to exist, can enable a general contractor to
withhold undisputed amounts owing from a subcontractor.
That approach was flatly rejected this year in FEI Enterprises,
Inc. v. Yoon, B209862 (2d Dist. 2011), certified for
partial publication. In the published portion of this opinion,
the appellate court addressed the good faith dispute exception to
the prompt payment requirement set forth in section 7108.5 of the
Business & Professions Code (which the court noted contains
similar language to that found in sections 7107 and 10262.5 of the
Public Contract Code and section 3260 of the Civil Code). The court
rejected the subjective standard invoked by the Alpha
Mechanical court, stating "that decision did not make a
proper analysis of the meaning of the term "good faith
dispute" as it is used in section 7108.5." It explained
that the court in Alpha Mechanical essentially converted the
"good faith dispute" language into a "good faith
belief" standard. This court found such a standard to be
"unwarranted and unwise." Instead, unless the factual
circumstances dictate otherwise, an objective, "reasonable
person" standard should be used to determine whether a payment
from a contractor to a subcontractor is subject to a "good
faith dispute" under the prompt payment statute.
Hence, there are now two cases, in the third and fourth districts
respectively, which apply a subjective standard to the question of
whether a good faith dispute exists to excuse prompt payment and
one case in the second district which applies an objective standard
to the question.
PRACTICE TIP: If your client's dispute
arise in one of the aforementioned districts, you can expect the
court will most likely follow the precedent set by its own
district. If the dispute arose in another district, it will be
difficult to predict how a court would rule; hence, it is prudent
to be conservative in recommending strategy and predicting
outcomes.
Footnote
1. Martin Brothers also sought to recover penalties under Bus. & Prof. Code § 7108.5 for Thompson's failure to make timely progress payments. The court found that the parties had agreed to an alternative payment scheme by the terms of their subcontract in which payment was expressly "not due until Subcontractor has furnished . . . applicable [lien] releases pursuant to Civil Code section 3262." Since section 7108.5 allows parties to "opt out" of its requirements via written agreement, and since Martin Brothers had not timely submitted the required lien releases, the court held that Thompson did not violate the prompt payment statute in failing to make a progress payment under the time constraints of the statute. Id., 179 Cal. App. 4th at 1415.
PRACTICE TIP: Subcontractors should take steps to assure that lien waivers, if required by the subcontract, are timely submitted with each invoice for progress payment.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.