Prompt Payment Penalties Overview

There have been a few cases in the past few years that affect the Prompt Pay Laws. The cases really do not support the application of prompt pay penalties except where there is absolutely no dispute over the unpaid amount due or the work. We often hear of contractors claiming they are entitled to 24% on unpaid balances because of these laws and usually their position is contrary to the law. Thus, we thought it was important to give an overview of where these laws are today.

For most projects, California requires the Owner of the project to pay the direct contractor progress payments within a statutory period (usually 30 days of the receipt of the demand for payment), unless there is a good faith dispute. The direct contractor is then required to pay its subcontractors no later than seven days (previously ten days) after receipt of said progress payment. In the event of a good faith dispute between the owner and direct contractor or the direct contractor and subcontractor, the person making the payment is allowed to withhold 150% of the disputed amount, and must pay the undisputed amount or the person wrongfully withholding payment will be subject to a two percent (2%) penalty, per month, to be applied to any improperly withheld amounts, and the prevailing party is also entitled to attorneys fees and costs upon prevailing in a court action.

Now, there have been three cases in the past five years that touch on these penalties, and in two cases, make the statute irrelevant. Knowing about these cases can allow you to change your dealings so you do not take yourself out of the right to penalties when you are wrongfully unpaid, or if you are the one withholding payment, you will know your rights to do so.

First, the use of the term "good faith dispute" often arises. In an appellate case decided in April 2011, FEI Enterprises, Inc. v. Yoon, the court dealt with the issue of what constitutes a "good faith dispute" and more particularly, how it is determined if it was truly a good faith dispute. This question is vital, if the amount is withheld in good faith, then there can be no application of Prompt Pay penalties. The case at issue discussed nonpayment of a subcontractor under Business and Professions Code section 7108.5. That statute does not define what a "good faith dispute" is, and the parties in the FEI case had a difference of opinion as to its interpretation. The Court of Appeal determined that while "good faith" could be examined in two ways, for this analysis only one made sense. The first examination was the "subjective" test, looking at the state of mind or belief of the individual withholding the money. The second view is an "objective" test, which looks at whether any reasonable person would objectively find the withholding in good faith. It was decided that the Legislature's intent was for a "good faith dispute" to be interpreted by objective means rather than any individual's own beliefs. In reality, it would be impossible to diffuse one's statement of their reason for withholding if it was entirely subjective. In the case at issue, the court felt that objectively, there was a basis for the withholding and therefore the direct contractor did have a "good faith dispute" and no Prompt Pay penalties were to be awarded to FEI.

Now, in two other cases, the Courts essentially took all of the teeth out of the statutes in two circumstances which are somewhat common in the industry.

In Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc., a subcontractor sought prompt pay penalties on unpaid retention where there was absolutely no dispute over the objection, but where the direct contractor had disputed entitlement to change orders. In this case, which seems to be an abomination of the purpose of allowing one to withhold money, because 150% of the amount of change orders was disputed, that sum could be withheld from retention due to the subcontractor. In our opinion, this certainly was not the intent of the Legislature in creating these laws. If the subcontractor had improperly performed work, 150% of the cost to correct that work should be able to be withheld. But, where the only dispute is whether it is entitled to additional compensation, it seems absurd to say that the retention can be withheld pending the resolution of the change order dispute. But, that is the law decided by the Court of Appeal. Thus, if you want to argue about change orders, know that the person withholding your payment will not be liable for prompt pay penalties if they hold retention hostage during the dispute.

In the last of these three cases, the court addressed what a payment was called. A prior case had already indicated that one could not collect prompt pay penalties under the statute for unpaid retention where there was no retention held under the contract. That case seemed misplaced when the payment certainly was for unpaid progress. It did seem like the wrong statute was applied in that case. But, that was not the issue in the case of Murray's Iron Works, Inc. v. Boyce, decided in January of 2008. In this case, there were just two payments to be made by the owner - a down payment and a final payment. The court held that a final payment, even though it was necessarily for progress of the work, was not a progress payment such that the penalties would apply. In Murray's, the owner withheld funds from the final payment in the same manner as a progress payment because there was a dispute as to whether the correct material was used to finish ornamental railings. The jury determined that the contractor properly performed, and that prompt pay penalties should be awarded. The trial court thus awarded the contractor the full amount of its requested contract damages, prompt payment penalties, and attorney's fees and costs under the Prompt Payment statute.

Although the Prompt Pay statute does not define "progress payments," the Court of Appeal held that "a payment made after construction is completed is not a progress payment..." Based upon this illogical ruling, we strongly recommend that all construction contracts call for multiple progress payments, and not payment in full on completion.

Again, it is very important for those in the construction industry to be aware of the interpretation of the prompt payment laws to be sure they are protected.

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Bruce Rudman has been practicing construction law for more than 17 years. He has garnered a great reputation in the construction field not only as a litigator but on licensing issues with the CSLB, particularly disciplinary proceedings. Abdulaziz, Grossbart & Rudman provides this information as a service to its friends & clients and it does not establish an attorney-client relationship with the reader. This document is of a general nature and is not a substitute for legal advice. Since laws change frequently, contact an attorney before using this information. Bruce Rudman can be reached at Abdulaziz, Grossbart & Rudman: (818) 760-2000 or by E-Mail at bdr@agrlaw.com, or at www.agrlaw.com