A recent court decision has introduced uncertainty as to the amount of money a public entity can retain upon completion of a public works contract. Public Contract Code section 7107 allows a public entity to retain funds otherwise due to a contractor based upon liens or in the event of a dispute between the public entity and the original contractor. If, however, the public entity wrongfully retains funds, section 7107 subjects the public entity to a penalty of two percent per month on the wrongfully withheld amount plus an obligation to pay the contractor's attorney's fees and costs.
East West Bank v. Rio School District
In the case of East West Bank v. Rio School District, Case No. B238618, filed April 1, 2015, the Court of Appeal addressed a dispute over the contract price between a school district and a contractor. In 1999, the contractor submitted a winning bid of $7.345 million to construct a school for the district. During construction, the contractor submitted approximately 150 change orders, but the district denied most of them. Construction was completed in 2001, but the district retained $676,436.49. The last stop notices were released in 2004, but the district refused to release any of the withheld retention due to the dispute over the change order payments. After a 243 day trial, the trial court sided with the contractor, and ordered the district to pay approximately $9.3 million to the contractor including damages, a statutory penalty, attorney's fees, costs and prejudgment interest.
On appeal, the Court rejected the district's argument that section 7107 allowed it to withhold the full amount of the retention since a good faith dispute existed between it and the contractor over the payment of the change orders. The Court noted that the purpose of the retention is to provide security against potential mechanics liens and to insure the contractor will complete the work. The public entity must pay the retention once the security is no longer required. The dispute over payment of the change orders did not require the district to retain the security. Noting that section 7107 was a remedial statute, the Court remarked that "Section 7107's purpose of ensuring the prompt release of retention funds would not be served if any dispute justified retaining the funds." Thus, a public entity cannot retain funds once the purpose of providing security against mechanics liens or deficiencies in the contractor's performance no longer exists.
As the Court concluded: "Once the legitimate purpose for retaining the funds end, the public entity must release the funds or suffer the statutory penalty . . . [and] District must not hold these funds hostage because it disputes amounts owed under the contract that includes numerous change orders." Although the Court ordered the trial court to reduce the $3.85 million award of attorney's fees on other grounds, it upheld the statutory penalty against the school district of approximately $1.5 million.
Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc.
In its decision, the Court in East West Bank expressly disagreed with the prior holding in Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc. (2009) 179 Cal.App.4th 1401. In that case, a contractor on a public works contract withheld funds from a subcontractor in reliance on section 7107. Similar to provisions governing disputes between a public entity and a general contractor, section 7107 contains provisions allowing a contractor to retain funds otherwise owed to a subcontractor.
Like the East West Bank case, the parties disputed whether payment for various change orders was appropriate. Unlike East West Bank, the Court in Martin Brothers determined that withholding of the retention is permitted whenever a bona fide dispute exists between the parties. "The statute contains no language restricting the word 'dispute' to any particular kind of dispute other than it must be 'bona fide.'" Thus, the contractor could withhold the retention and was not subject to statutory penalties since a bona fide dispute existed between the parties over the contract price and payment of the change orders.
What This Means For You
There is now a conflict between the appellate cases, so public entities must carefully evaluate whether or not to retain funds in disputes not involving a lien or a question of defective performance. A wrongful retention could subject a public entity to the statutory penalty and payment of fees. Ultimately, the Supreme Court or the Legislature will need to resolve this dispute in order to provide clear direction to both public entities and contractors. Interestingly, Justice Cantil-Sakauye, the author of the Martin Brothers decision that the Court in East West Bank rejected, is now the Chief Justice of the Supreme Court. Perhaps this will be another reason for the Supreme Court to step-in and resolve this issue.
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