School District’s Application of the "Golden Rule" Backfires

Our readers are likely acquainted with business’ “Golden Rule”:  “The party who holds the ‘gold’ (money) makes the rules.”  When parties to a contract know that their dispute is headed to litigation or arbitration, an “upstream” party is often tempted to use whatever leverage it has, including withholding of funds, to force resolution of the claim.  For example, holding funds otherwise due to a subcontractor when a claim arises, the general contractor may believe it can leverage the subcontractor into a more expeditious settlement position by “starving” the subcontractor of funds otherwise due and owing.  This type of heavy-handed dealing does not generally sit well with arbitrators, judges, or juries, and can result in large damage awards, or “homeruns” against the party exercising this undue leverage.  An example of the Golden Rule backfiring occurred in the East West Bank v. Rio School District. 235 Cal. App. 4th 742, 185 Cal. Rptr. 3d 676 (2015).

In this case, disputes arose from a school project in California.  In 199, a general contractor, FTR, submitted the winning bid to the Rio School District and was awarded a contract for a $7.3 million school remodel.  During construction, FTR submitted more than 150 proposed change orders (“PCO”).  FTR claimed that the PCOs were necessary because the plans provided by the District were inadequate or misleading.  The District denied most of the PCOs on the grounds that the work was covered under the basic contract (the work was within the scope), the amounts were excessive, or that the PCO was not timely under the contract (the notice defense).  Construction was completed in June of 2001 and the school was occupied in May of 2001.

The District withheld retention and at the end of the project had a retainage fund of $676,436.49.  FTR subcontractors had filed claims against the retainage.  However, the last claims against the retention were released in September of 2004.

Despite there being no claims against the retention, the District refused to pay the balance due under the contract, and refused to pay anything other than a small portion of the PCOs.  In addition, the District withheld all of the retention.  FTR sued the District to recover damages for breach of contract and statutory penalties under California law for wrongfully withholding the retention as well as attorneys’ fees, interest, and costs.  The District filed a counterclaim against FTR for 416 alleged violations of the California False Claims Act.[i]  After a 243-day trial, the trial court found in favor of FTR and awarded the contractor $9.4 million, including the contractor’s contract balance, extra work performed by FTR, delay and disruption caused by the District, and statutory penalties for wrongfully withholding the retention.  In addition, the contractor was awarded attorneys’ fees, prejudgment interest, and costs.  This verdict is commonly known as a “homerun” in construction law circles.  The Court went out of its way to set an example and punish the District for its wrongful withholding.

In making its award, the Court enforced the following California statute, which addresses the prompt payment of retained funds to contractors:

Within 60 days of the date of completion of the work of improvement, the retention withheld by the public entity shall be released.  In the event of a dispute between the public entity and the original contractor, the public entity may withhold from the final payment an amount not to exceed 150% of the disputed amount.[ii]

That statute is similar to the Washington Retention Act and Prompt Payment statutes in Washington, Oregon, and Alaska.  In California, however, the statute allows a 2% per month statutory penalty for wrongful withholding, which the Court assessed at $1.5 million.  In the face of such a large award, it was hardly surprising that the District filed an appeal alleging that the trial court erred in awarding the statutory penalties.  The District’s basis for its appeal was that there was a “good faith” dispute and, therefore, it was entitled to withhold the retained funds and avoid the penalties.

The California Court of Appeals began its analysis by setting forth the ultimate purpose of retention, which is to ensure that the public works owner has sufficient funds to complete or correct the defective or unfinished work and to provide securities against mechanics liens.  The District’s argument that a “good faith” dispute existed was based on the fact that the contractor’s claim was the supposed “dispute” which entitled the owner to withhold all of the retention funds.  As far as the District was concerned, as long as there was any dispute, whether it was the contractor’s claim or the dispute brought by the District, the District was entitled to withhold the retention.  This is an absurd notion that the District could withhold the contractor’s money if the contractor brought a claim under the contract.

The Court disagreed with the District’s broad interpretation of “dispute” and reasoned that the purpose of ensuring that the prompt release of retained funds would not be served if “any dispute” justified withholding of retainage funds.  Once the legitimate purpose for retaining the funds ends, the Court held that the public entity must release the funds or suffer the statutory penalty.  The statutory penalty is in place to deter public entities from improperly withholding retention payments.

By any objective measure, it is difficult to argue that the District’s withholding was justified in the absence of any corrective work and merely because the contractor had submitted a claim.  It is particularly difficult to see how this justification would fly after ten years of retention.

Comment:  Although different than California’s, Washington, Oregon, and Alaska have Prompt Payment Act provisions that are similar to the California Civil Code referenced in this case.  The Golden Rule should be rewritten for construction contracts to be: “do not use the leverage of withholding undisputed amounts (“gold”) to force your opposition to capitulate.”  Never hold undisputed amounts from someone who is owed those monies simply to parlay that withholding into leverage to force resolution.  That strategy backfires more often than not, as this case demonstrates.

[i] According to our California construction colleagues, many contractor construction claims are met with false claim counterclaims, which is a good reason to continue to oppose false claims legislation in Washington.

[ii] California Civil Code §7107.

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