Prompt Payment Penalty Statutes: What is a bona fide dispute anyway?

In California, the payment of contractors and subcontractors is governed by "prompt payment statutes,” which impose sanctions on the non-paying party for failure to timely pay.  These statutes are littered throughout the Code:  for example, progress payments by general contractors to their subcontractors on private and most public works of improvement are governed by Business & Professions Code § 7108.5; retention payments to subcontractors on public works are governed by Public Contracts Code § 7107, and Civil Code § 3260 for private works. These sanctions range from a 1.5% to 2% per month penalty on the wrongfully withheld balance in lieu of interest, the 2% penalty plus interest, or statutory interest alone, and in some cases attorney fees and costs.

Although there are subtle differences amongst the payment obligations imposed by these statutes, generally, payment must be released to subcontractors within a specified time following receipt by the contractor, except when there is a dispute, or when the parties have agreed in writing to a different payment plan.  If there is a "good faith dispute over all or any portion of the amount due on a progress payment," the general contractor may withhold up to 150 percent of the disputed amount. (Bus. & Prof. Code § 7108.5(c).) On a public work, "if a bona fide dispute exists between the subcontractor and the original contractor," then the latter may withhold from retention up to 150 percent of the estimated value of the disputed amount.  (Pub. Cont. Code § 7107(e).)  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." (Civ. Code § 3260(e).)

So, what constitutes a bona fide, or good faith, dispute?

Alpha Mechanical, Heating & Air Conditioning, Inc. v. Travelers Casualty & Surety Company of America (2005) 133 Cal.App.4th 1319, was the first court decision to expressly examine the merits of a good faith dispute on a private work of improvement, analyzing Bus. & Prof. Code § 7108.5 and Civ. Code § 3260.  Therein, the court observed "the phrase 'good faith' does have a distinct meaning and purpose in the law," and "suggests a moral quality; its absence is equated with dishonesty, deceit or unfaithfulness to duty," 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."  (Alpha Mechanical, supra, 133 Cal.App.4^th at 1339.) 

Alpha Mechanical involved a common dispute over work performed under a subcontract:   the general contractor alleged it did not make final payment to its subcontractor because the sub failed to correct defective work and damaged the work of other trades, requiring repairs the general would have to pay for if the subcontractor did not make the repairs. The court of appeals found no evidence in the record suggesting 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., at 1340.)  Therefore, the general was not liable for prompt payment penalties.

In a more recent case, Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc. (2009) 179 Cal.App.4th 1401, a dispute arose on a public work over changes the subcontractor contended were outside its scope of work and for which additional compensation was owed.  The general contractor withheld the subcontractor’s retention (over which there was no argument as to the amount owed) due to the dispute over changes.  The subcontractor sought penalties under Public Contract Code § 7107 for the general contractor’s failure to release its retention. The court of appeal in Martin Brothers held the reference in the statute to "dispute" meant any dispute, so long as the dispute was bona fide.  In other words, even though there was no dispute over the amount of retention owed under the subcontract, the general contractor was justified withholding retention while the change order dispute was pending.  The ruling was somewhat surprising to the legal community, because it allowed the general contractor to withhold undisputed sums due to a dispute over whether additional sums were owed.

                                

As you can see from these two examples, whether a dispute is bona fide or in good faith could be interpreted broadly to suggest that nearly any dispute, provided it was genuinely asserted, enabled a general contractor to withhold amounts owed a subcontractor.

 
But just recently, the good faith dispute exception in Section 7108.5 of the Business & Professions Code (which the court observed was similar to Sections 7107 and 10262.5 of the Public Contract Code and Section 3260 of the Civil Code) was narrowed by a different court of appeal.  In the published portion of the opinion in FEI Enterprises, Inc. v. Yoon (2d Dist. 2011) B209862, the court criticized Alpha Mechanical’s “unwarranted and unwise” imposition of a subjective standard, which converted the express language of the statute from a stated "good faith dispute" into a "good faith belief" standard.  Unless the factual circumstances dictate otherwise, the FEI Enterprises court held 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."

Where does that leave the California contracting community?  There are now two cases, one in each of the third[1] and fourth[2] districts, applying a subjective standard to the decision of whether a good faith dispute exists to excuse prompt payment, and one case in the second[3] district applying an objective standard to that same question.  If your dispute arises in one of these districts, your trial court will likely follow the precedent set by the appellate court in its own district. If the dispute arises elsewhere, it will be difficult to predict how a court will rule.  Therefore, applying the more conservative, objective standard is likely the most prudent course to follow when analyzing the facts of your case, and deciding your legal strategy.

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[1] The Third District of California’s Court of Appeal is located in Sacramento, and has jurisdiction over appeals arising in Alpine, Amador, Butte, Calaveras, Colusa, El Dorado, Glenn, Lassen, Modoc, Mono, Nevada, Placer, Plumas, Sacramento, San Joaquin, Shasta, Sierra, Siskiyou, Sutter, Tehama, Trinity, Yolo, and Yuba Counties.

[2] The Fourth District of California’s Court of Appeal has courts in Riverside, San Diego and Santa Ana and has jurisdiction over appeals arising in Inyo, Riverside, San Bernardino, Imperial, San Diego and Orange Counties.

[3]  The Second District of California’s Court of Appeal has courts in Los Angeles and Ventura, and has jurisdiction over appeals arising in Los Angeles, Ventura, Santa Barbara and San Luis Obispo Counties.