Prompt Payment” Statutes and the Contractor’s Twilight Zone after Taylor v. Van-Catlin Construction

By James E. Sell

With apologies to Rod Serling, you are about to enter the Contractor's Twilight Zone.

You are a Contractor. An Owner owes you money for progress payments and/or your final retention payment. The Owner refuses to pay, claiming there is a "bona fide" or "good faith" dispute. You are convinced the Owner is simply holding your money in bad faith. The amount you are owed won't put you out of business, but you cannot justify writing it off either. Unfortunately, there is no attorney's fee provision in your contract with the Owner, so you question whether it is even economically worthwhile to hire an attorney to pursue your money. However, under California's "prompt payment" statutes, you know that if you file suit and it is found that the Owner "wrongfully" withheld your money, then you are entitled to recover your attorney's fees plus a 2 percent penalty per month on the unpaid sums.

So you file suit against the Owner, claiming breach of contract and violation of the "prompt payment" statute. The case proceeds to trial. The court rules that the Owner breached the contract and that you are entitled to recover all of your money on the contract. However, the court finds that the Owner did not violate the "prompt payment" statute because there was a "bona fide" dispute over the withheld money. You have now entered the Contractor's Twilight Zone. Because of a recent Court of Appeal decision and your trial court's finding that the Owner did not violate the "prompt payment" statute, you are now liable for the Owner's attorney's fees, despite the fact the court found that the Owner breached the contract. As it turns out, the Owner's attorney's fees far exceed the amount you were owed in the first place. To make matters worse, you have to pay your own attorney. In the end, despite winning your breach of contract claim, you have to come out of pocket and have actually lost money. This Twilight Zone nightmare should never happen to you, but it could...

Prior to 1990, Owners had an economic advantage over Contractors because, other than the contract itself, there was no specific law governing when progress payments and retention payments had to be paid. Contractors complained that unscrupulous Owners would withhold payments for open-ended periods, collect interest on the funds, levy improper backcharges, or reject close-out submittals on frivolous grounds, as excuses for non-payment. The Contractor could always sue the Owner for payment, but, more often than not, there was no way for the Contractor to recover its attorney's fees pursuing the Owner, therefore making it economically unfeasible to do so. Thus, the Contractor was often forced to wait patiently for its money or was forced to take pennies on the dollar.

In the early 1990s, the California Legislature recognized this economic hardship placed on Contractors (and Subcontractors) who are not timely paid and passed prompt payment statutes embodied in California Civil Code § 3260 (private works) and California Public Contract Code § 7107 (public works). The prompt payment statutes for private works and public works are essentially identical, the only significant difference being the timing in which payments must be made.

The prompt payment statutes generally provide that an Owner may withhold up to 150 percent of a disputed progress payment and/or final "retention" payment where there is a "bona fide" or "good faith" dispute. To deter unscrupulous Owners, the Legislature provided a remedy for the Contractor, whereby the Owner must pay a 2 percent per month penalty to the Contractor on any "improperly withheld" funds, i.e. where there is no "bona fide" or "good faith" dispute. The statutes also provide that the "prevailing party" in any action to recover the "wrongfully withheld" funds shall be entitled to attorney's fees. The net effect of the statutes was to level the playing field by basically providing Contractors with additional remedies in the event the Owner breached the contract by failing timely to make payment or by refusing to make payment based on frivolous excuses.

Unfortunately, the recent decision of Taylor v. Van Catlin has arguably eviscerated that Legislature's laudatory goal to protect Contractors from unscrupulous Owners. In our last issue ofValue Added, we commented on Taylor, where homeowners hired a contractor to remodel their home under an agreement that contained an arbitration clause but no attorney's fees clause. When the homeowners refused to pay the full amount, the contractor initiated arbitration, in which it sought recovery of the contract balance, plus the 2 percent penalty and attorney's fees under Civ. Code § 3260. The arbitrator found the contractor's work to be "materially substandard" and entered an award for the homeowners that included the homeowners' attorney's fees. The contractor challenged the arbitration award and the trial court deleted the award of the homeowners' attorney's fees on grounds that the arbitrator had exceeded his jurisdiction and that such fees were not recoverable under Civ. Code § 3260(g) because there existed a "bona fide" dispute between the parties.

On appeal, the court in Taylor held, in what is arguably dicta(i.e., extraneous discussion that is not necessary to the decision and not binding law) that the provision in Civ. Code § 3260(g) for recovery of attorney's fees by the "prevailing party" means that either the contractor or the homeowner may recover its attorney's fees. In doing so, Taylor suggested that the 2001 decision of Darling v. Controlled Environments Construction, Inc. misconstrued the attorney's fees provision in the prompt payment statute.

In Darling, the court interpreted Section 3260(g) to mean that attorney's fees are recoverable only when the 2 percent penalty is also recoverable, i.e., only when no bona fide dispute exists between the parties. Darling reasoned that "[i]t would seem that if the Legislature had intended to provide for an award of attorney's fees to the prevailing party in every action for collection of retention funds, the provision would have been placed in a separate paragraph." Thus, "[t]he 2 percent penalty and the attorney's fees provision are directed at the more egregious situation in which a contractor [or Owner] withholds payment of retention proceeds beyond specified time periods and without cause."

In reaching the opposite conclusion, Taylor disagreed with what it perceived to be Darling's "broad language," which effectively resulted in recovery of attorney's fees by the contractor only, since the owner would never be in the position of seeking the 2 percent penalty under Civ. Code § 3260(g). Taylor reasoned that "[i]f the Legislature had intended only the successful demanding party to receive attorney's fees, it would have so stated instead of permitting an award to the 'prevailing party.' There is simply no logical reason to punish the party who was not at fault-who justifiably retained payment in good faith-by denying that party attorney's fees for successfully defending against the other party's action for payment."

Granted, the attorney's fees provision in the prompt payment statute is hardly a model of clarity. It provides:

  • In the event that retention payments are not made within the time periods required by this section, the owner or original contractor withholding the unpaid amounts shall be subject to a charge of 2 percent per month on the improperly withheld amount, in lieu of any interest otherwise due. Additionally, in any action for the collection of funds wrongfully withheld, the prevailing party shall be entitled to his or her attorney's fees and costs.

Nevertheless, when one considers the Legislature's goals in creating the prompt payment statutes, it is evident that Taylormisconstrued the statute and that Darling is the better reasoned decision.

From a legal perspective, in holding that either party may recover its attorney's fees under Civ. Code § 3260(g), Tayloroverlooks the fact that the attorney's fees provision was specifically included in the 2 percent penalty section and not in a separate paragraph, as noted in Darling. This is consistent with the intent of the Legislature in enacting Civ. Code § 3260-to compensate contractors who are forced to litigate wrongfully withheld funds. Indeed, Darling specifically addressed Legislative history behind the statute, while Taylor makes no mention of (or ignored) it.

From a "real life" perspective, a Contractor who files a lawsuit against an Owner for breach of contract and violation of the prompt payment statute has significant risk and an uphill battle, especially where there is otherwise no right to recover its attorney's fees. The Contractor first has to retain an attorney to pursue the Owner. The Contractor then must prove that it performed the contract and that the Owner breached the contract by not paying for the work. Then to recover the 2 percent penalty and the attorney's fees pursuant to the prompt payment statute, the Contractor must also prove that the Owner did not have a "bona fide" or "good faith" excuse for not making payment. In other words, the Contractor probably has to affirmatively prove the Owner acted in bad faith, which is arguably a difficult burden. If the Contractor prevails on the breach of contract claim, but fails to establish a prompt payment violation, it is still on the hook for its own attorney's fees, which may equal or exceed the contract balance it recovers. Thus, while the prompt payment statute provides the Contractor with additional remedies, it does not necessarily provide the Contractor with a windfall or an unfair advantage. Rather, it is designed to compensate the Contractor for having been forced to retain an attorney to recover from the Owner payments wrongfully withheld in the first place.

Taylor now places an even greater risk on the Contractor who files suit against an Owner for breach of contract and violation of the prompt payment statute. Although the discussion of attorney's fees in Taylor is arguably nonbinding dicta, it now provides ammunition for the attorney representing an Owner who loses on the breach of contract claim, but who prevails on a "prompt payment" claim, to argue that it is entitled to attorney's fees. Before Taylor, no court had held or even suggested that a Contractor who lost a "prompt payment" claim was then required to pay the Owner's attorney's fees as a consequence. Taylor effectively eliminates the Contractor's chance of recovering its attorney's fees provided under the prompt payment statutes, reduces the Owner's incentive to deal with the Contractor in good faith, and may chill a Contractor's decision in the future to pursue the Owner for payment of simply the contract balance alone. This was not the intent of the Legislature when it passed the prompt payment statutes.

Taylor found it illogical that the party who withheld funds in good faith could never recover its attorney's fees under the prompt payment statute. However, given the intent of the statute, this result does not seem inconsistent with the Owner when it signs the contract. If an Owner wants the "prevailing party" in any lawsuit over payment to be entitled to recover attorney's fees, the Owner can provide for such a provision in the contract, since it usually has the stronger bargaining power when the contract is signed. However, Owners tend not to include attorney's fees provisions in their contracts because they usually have everything to lose and little to gain by including them. As a result, an Owner defending a breach of contract action pursuant to a purported "bona fide" dispute is not put in any worse position defending against a Contractor's "prompt payment" claim. If it is found that the Owner properly retained funds pursuant to a "bona fide" dispute, then it is entitled to retain the funds and pays its own attorney, as originally contemplated by the Owner when it entered into the contract. Likewise, if it is found that the Owner "wrongfully withheld" the funds, then it is responsible for the Contractor's attorney's fees and the 2 percent penalty, as contemplated by the prompt payment statute. Such a risk or result should not be unexpected by the Owner. The Owner presumably knows the law and if it is found that the funds were "wrongfully withheld," the Owner should have every expectation to pay the 2 percent penalty and the Contractor's attorney's fees. There is nothing illogical or inequitable with such a result.

Darling is the better reasoned decision with respect to the prompt payment statute and the recovery of attorney's fees. Unfortunately, Taylor was not appealed to the Supreme Court or ordered depublished and so it remains "on the books." The Legislature should amend the prompt payment statutes to make the right to recover attorney's fees more clear and consistent with the interpretation of Darling. In the meantime, unpaid Contractors and Subcontractors who believe their money has been wrongfully withheld will have to think long and hard the next time they decide to file an action that includes a claim for violation of the "prompt payment" statute. For if they include a claim for violation of the prompt payment laws and lose, they may well find themselves in the Contractor's Twilight Zone.