Public Contract Code section 7107 (section 7107) sits at the center of controversy between two appellate courts. In East West Bank v. Rio School District, 2d Civil No. B238618 (Ct. of App., 2nd. App. Dist., Div. 6, 4/1/15) (“East West Bank”), the Court concluded that a disagreement over a contract price does not give a public entity the right to retain funds due a general contractor. In finding that the school district wrongfully withheld the retained funds from the general contractor, the Court explicitly disagreed with the decision rendered in Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc. (2009) 179 Cal. App. 4th 1401 (“Martin Brothers”)
In Martin Brothers, the 3rd District Court of Appeal, considered a similar factual situation, the only difference being that a general contractor on a public school project withheld retention funds due a subcontractor. The subcontractor claimed that it was not only owed the retained funds, but that it was also owed money due to change orders. Rather than pay the subcontractor the retained funds, the general contractor retained them maintaining that a bona fide dispute existed between the general contractor and the subcontractor, and therefore, it was not obliged to pay the retention until the dispute was resolved. The subcontractor sought a two percent per month penalty against the general contractor pursuant to Public Contract Code section 7107(f) for failure to release funds to the subcontractor within seven days of the release of the release of funds on the general contract as required by section7107(d). The Court held in the general contractor’s favor, concluding that section 7107(e) “applies to any good faith dispute between a general contractor and subcontractor.” (Martin Brothers, supra, 179 Cal. App. 4th at 1414.)
The East West Bank decision concerned the construction of a school for the Rio School District. In 1999, FTR International Inc. (“FTR”) proffered the winning bid of $7.345 million to construct a school for Rio School District. Over the course of construction, FTR submitted 150 proposed change orders (“PCOs”). FTR claimed that some of the PCOs stemmed from the inadequate or misleading plans employed by the District. The District rejected most of the PCOs alleging that the basic contract covered the work, that FTR claimed excessive amounts, and that a PCO was untimely under the contract. FTR completed construction in June 2001. The District filed a notice of completion on August 7, 2001. The school has been occupied since May 2001.
By contract, the District retained 10% of each progress payment, so by the time the general contractor and subcontractors completed their work, the District held in reserve $676,436.49. Due to stop notices, the District retained the money for an extended period of time, but finally, on September 28, 2004, the last of the stop notices was released.
Despite the release of the stop notices, the District repudiated FTR’s request for the balance due under the contract, FTR’s request for a majority of the amounts claimed in the PCOs, and FTR’s request for damages caused by delay and disruption. The District’s recalcitrance prompted FTR to sue the District to recover damages for breach of contract, statutory penalties under Public Contract Code section 7107 (section 7107), attorney fees, interest and costs.
Section 7107 states, in pertinent part:
(c) Within 60 days after the date of completion of the work of improvement, the retention withheld by the public entity shall be released. In the event of dispute between the public entity and the original contractor, the public entity may withhold from the final payment an amount not to exceed 150 percent of the disputed amount....
(f) In the event that retention payments are not made within the time periods required by this section, the public entity or original contractor withholding the unpaid amounts shall be subject to a charge of 2 percent per month on theimproperly 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 attorney’s fees and costs....
FTR averred that section 7107 prohibited the District from refusing to release the retained funds within the 60 day time period prescribed by the statute and that the statute supports an award of penalties. After a protracted court trial, the trial court found in FTR’s favor and awarded it in excess of $9 million, which included damages for the balance due under the contract, extra work performed by FTR, delay and disruption caused by District, statutory penalties pursuant to section 7107, attorney fees, prejudgment interest and costs.
On appeal, the District argued that the trial court erred by awarding penalties to FTR as it was entitled to withhold all the retention because there was a good faith dispute between FTR and the District over how much the District owed FTR. The Court dismissed this argument because the District completely ignored the rationale for the retention. Retentions serve “as a form of security against potential mechanics’ liens and as security that the contractor will complete the work properly and repair defects.” (Yassin v. Solis (2010) 184 Cal. App.4th 524, 534.) “Once the legitimate purpose for retaining the funds ends, the public entity must release the funds or suffer the statutory penalty.” (East West Bank, supra, _____.) Therefore, the Court upheld the trial court award of the statutory 2% per month penalty.
With the appellate courts in disagreement, this appears to be an issue ripe for consideration by the California Supreme Court. However, since there does not appear to be a case before the Supreme Court at this juncture and in light of the significant penalties that may attach in a public contract situation if either a public entity or general contractor refuses to pay retained funds, it seems that the prudent decision would be to not attempt to use those funds as leverage should other disputes exist as to payments beyond those addressed by the original contract.