Fundamentals of Construction Contracts in California: Understanding the Issues

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July 26, 2018


I. PROGRAM OVERVIEW

This portion of the program is designed to address basic contract principals and issues for subcontractors. The program is intended to be uses as an outline to spot some of the issues that are common for subcontractors in private works and the public works projects.

Government contracts are also issued for the federal government for work done in California. For example, contracts are issued by the Army Corps of Engineers, Department of the Navy, Department of the Air Force, Department of Veteran Affairs, Postmaster General, etc. Federal public works jobs have a different venue and have very different public works issues than we will discuss in this seminar. We will not be addressing the federal public works issues except to mention them to compare to some of the California issues and requirements.

There are many differences between public works and private works construction. Private construction includes commercial and residential construction that is not funded by public money. There are differences in bidding, in use of the multiple prime system and/or use of a construction manager, design build projects, mechanic’s lien vs. stop notices, performance and payment bond remedies, statutory remedies triggered by notice of completion or certificate of occupancy, bid protest statute of limitations, and some notice requirements.

This information is not intended to be exhaustive. Also, we recommend that you perform independent legal research on all these issues and not necessarily rely on the cases and statutes which are cited by us today. The code sections cited are all California state statutes unless identified as not being from California.

When dealing with any contract, one of the most critical areas is the clause that addresses how the contractor will be paid. Typically, most of the work on any construction contract is performed by numerous subcontractors, each of whom enterers into a separate written agreement with the prime or general contractor. In this portion of the seminar, prime and general contractor are treating interchangeably. In California, “prime contractor” generally means a contractor who has a direct contract with the owner. Thus, on contracts using a construction manager or multiple prime system, the traditional subcontractor trades may in fact be a prime contractor.

Generally, although this is changing throughout the industry especially in California, the subcontractor has no direct contractual relationship with the owner. As a result, it is generally viewed to be essential to the smooth operation of a project that the contract terms between general contractor and its subcontractors must meet the obligations the general contractor has to the owner. As a result, most “subcontracts” are very comprehensive in an attempt to be consistent with requirements of the contract between the owner and general.

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If an owner requires certain information on the general contractors payment application and requires those payment applications by a certain date, the subcontracts generally require that the subcontractors supply the general contractor with the same information far enough in advance of the due date to enable general contractor to have a fully prepared payment application submitted in a timely manner.

Most payment clauses require subcontractors to submit mechanic’s lien releases for themselves and any other of their sub-subcontractors or material suppliers as a condition of receiving payment. The type of releases required are mandated to have certain language by statute and are either conditional upon progress or retention or final upon progress or retention.

II. PAID WHEN PAID CLAUSES

The subcontractors right to be paid and the general contractors duty to pay in the event of non-payment by the owner is an issue that must be considered in an examination of every contract. This examination leads to consideration of when the general contractor must pay the subcontractors if the general contractor is not paid by the owner in a timely manner. It should be noted, that in absence of a dispute as to the quality of a subcontractors work, Yamanishi v. Bleily & Collishaw, Inc. (1972) 29 Cal.App.3rd 457 held that the subcontractor is entitled to be paid within a reasonable time even if the owner has withheld retention from the prime contractor and even if the subcontractor provides that the subcontractor is to be paid when the owner pays the prime contractor. The court held the question was when the contractor must pay the subcontractor. The subcontract involved in that case stated:

Contractor agrees to pay the subcontractor upon receipt of each payment received from the owner the portion of said payment allowed to the contractor on account of subcontractors work to the extent of subcontractors interest therein was any percentage retained under said general contract.

Some subcontract agreements contained stronger language making payment by the owner to the general contractor a “condition precedent” to a general contractors obligation to pay the subcontractor. The general contractor inserted this language to avoid having to finance the job out of his own funds. However, in Clarke v. Safeco Insurance Company (1997) 15 Cal.App.4th 882, the California Supreme Court ruled that a “pay if paid” provision in prime contractors agreement with a subcontractor was void because it resulted in an indirect forfeiture of the subcontractors constitutional protected mechanic’s lien right.


As a result of the Clarke decision it is clear that a general contractor is obligated to pay its subcontractors within a reasonable time whether or not the prime contractor has received payment from the owner. Many general contractors are adding contract provisions defining “reasonable time.” Many of these general contractors are defining that reasonable time is a period of time not shorter then that which is necessary to prosecute to conclusion litigation against the owner.

The Civil Code and Business and Professions Code (for private works) and the Public Contract Code (for public works) have sections which provide for “prompt payment.” The sections cover payment of retention as well as progress payment. In general, the general contractor must pay the subcontractor within 10 days of receipt of payment from the owner or public entity. Private works are covered in Civil Code section 8810 and 8812 and Business and Professions Code section 7108.5. Public works are covered in Public Contract Code sections 7107 and 10262.5.

III. FLOW DOWN CLAUSES

It is fact of life that general contractors to attempt to ensure appropriate terms in its contract with the owner are passed to its subcontractors by adopting flow down provisions in each of its subcontracts. The incorporation of contracts documents and flow down provisions are the best method for the general contractor of insuring there are no variations between its obligations to the owner and subcontractors obligations to it. Almost every owner/general contractor contract will require that each of the subcontractors on a project adopt the basic owner-contractor agreement and agree to be bound of the terms of that contract or other designated flow down provisions.

Subcontractor which have such a provision in their subcontracts must read their subcontract to determine their rights, obligations, duties and review the general and special conditions and contract provisions which are adopted between the owner and general contractor to determine how matter the contract will operate. Examples of issues that are normally affected are scheduling, time extensions, dispute resolution and change orders.

IV. INDEMNITY

California Senate Bill 474 (SB 474), signed into law by Governor Brown on October 9, 2011, provides that provisions in commercial construction contracts entered into on or after January 1, 2013 that require the parties to indemnify or defend an owner for its active fault, or require a subcontractor to defend, indemnify, or insure a general contractor or construction manager for the active fault of others, or to the extent that the claim does not arise out of the subcontractor’s scope of work on the project, are deemed to be against public policy and are null and void.

Under current practice, California developers and general contractors typically use what is referred to as a “Type I” indemnity provision in construction contracts. “Type I” indemnity allows one party (usually owners, developers, and general contractors) to require the other party (typically subcontractors) to indemnify them for their own active negligence or fault. Although some legislative changes have been made to ameliorate the effects of Type I agreements in the context of residential construction, SB 474 extends these protections to commercial projects.

What It Does

SB 474 amends California Civil Code Section 2782 and adds a new Civil Code Section 2782.05. The new amendments are lengthy and complex. In summary:

Construction Contracts: Indemnification. Provisions in commercial construction contracts entered into on or after January 1, 2013, that require a subcontractor to indemnify a contractor, construction manager, or another subcontractor to pay for the cost of defending against claims for the 1) active negligence of others, 2) willful misconduct of others, 3) design of others, or 4) to the extent that the claim does not arise out of the scope of work of the subcontractor, are against public policy and are unenforceable. In essence, this means that each party will be held liable to the respective degree to which it is found to be at fault for any kind of claim, including property damage or bodily injury. Civil Code Section 2782.05 (a).

Construction Contracts: Defense Obligation. The parties to a commercial construction contract entered into on or after January 1, 2013, remain free to contract to require the subcontractor to pay for or provide a defense for the contractor or construction manager arising out of a claim allegedly involving the subcontractor’s work on the project until such time as a determination is made that the subcontractor is not required to indemnify the contractor or construction manager. The amendment sets forth a complex scheme, similar to existing law for residential construction contracts, under which the subcontractor, following receipt of a proper tender of the claim and pertinent claim information, has the option to defend the portion of the claim related to its scope of work or pay "no more than a reasonable allocated share" of defense costs. If the subcontractor fails to properly or adequately defend the claim, the general contractor or construction manager may pursue it for compensatory and consequential damages and attorney’s fees and costs. Civil Code Section 2782.05 (e)–(f).

Construction Contracts: Public Entities. Existing law provides that any contractual provisions that attempt to impose on a contractor or relieve the public agency from liability for the public agencies’ own active negligence are void and unenforceable. SB 474 extends to subcontractors and suppliers the protection against indemnification for the public agencies’ own active negligence. Civil Code Section 2782 (b).

Construction Contracts: Private Owners. As with public entities, the SB 474 amendments provide that, for any contracts entered into on or after January 13, 2013, any contractual provisions that purport to impose on a contractor, subcontractor, or material supplier, or relieve an owner (who is not acting as a general contractor, supplier, or construction manager) from liability for the owner’s own active negligence are void and unenforceable. Civil Code Section 2782 (c). A homeowner performing home improvement work on his own home is excluded from this amendment. Civil Code Section 2782 (c) (3).

What It Does Not Do

The new Civil Code Section 2782.05 (a) does not apply to residential construction contracts involving original construction intended to be sold as an individual dwelling unit. Civil Code Section 2782.05 (b) (1). Residential construction is instead governed by the amendments that were part of AB 2738, passed in 2008.

The new Civil Code Section 2782.05 (a) does not appear to extend the same protections afforded to subcontractors to suppliers. The definition of “subcontractor” in the amendment may arguably be broad enough to be inclusive of a pure supplier. There is no doubt this will be an issue to be resolved in the courts or through further clarifying legislation.

While the new Civil Code Section 2782.05 (a) prohibits construction managers from requiring subcontractors to indemnify or defend them pursuant to Type I obligations, the SB 474 amendments are silent as to design professionals, and whether contract documents for a project may contain language that requires general contractors, subcontractors, or material suppliers under certain circumstances to insure, defend, or indemnify a design professional where that design professional is not functioning in the capacity of construction manager.

AB 2738, passed in 2008, implemented protections for subcontractors on residential projects where wrap insurance programs were purchased for the project. The SB 474 amendments contain no such protections for subcontractors on commercial projects.

The SB 474 amendments do not prohibit homeowners on single-family home remodel projects to require Type I indemnity or insuring obligations in their favor. Civil Code Section 2782 (c) (3).

Future Issues

The gaps, the questions, and the issues that remain for the future scheme for indemnity under Civil Code Section 2782, et seq., include:

- Will suppliers, like subcontractors, benefit from the new protections against Type I indemnity obligations on commercial projects?

- The new Civil Code Section 2782.05 (a) prohibits public entities, private owners, general contractors and construction managers from requiring indemnification for their own active fault on commercial construction projects. Subcontractors, under the new SB 474 amendments, have the added protection that they cannot be forced to indemnify general contractors and construction managers to the extent that the claim does not arise from the work of the subcontractor. Therefore, in the future general contractors will find it substantially more difficult to leverage a subcontractor to pay for damages caused by a different subcontractor’s work.

- Under the SB 474 amendments, subcontractors can no longer be required to insure a general contractor, construction manager, or another subcontractor to the extent that the claim arises out of the conduct of parties other than that subcontractor. The question arises, what does “insure” mean in this portion of SB 474? The Legislative history behind SB 474 discusses the intended purposes of the amendments and the prohibition of obligations by subcontractors to procure additional insured coverage, insuring the active fault of the general contractor, construction manager or other subcontractors.

This bill provides that a provision in a contract that requires the purchase of additional insured coverage, or any coverage endorsement or provision within an insurance policy providing additional insured coverage, primary or noncontributing coverage or waivers, is void and unenforceable to the extent that it requires or provides coverage the scope of which is prohibited under this bill for an agreement to indemnify, hold harmless, or defend. Bill Analysis, page 6, Senate Floor, May 31, 2011.

The language in SB 474 appears to have originated from AB 2738, pertaining to residential defect construction. And, there is very little evidence in the legislative record for AB 2738 concerning the purpose or intent behind this same language. Counsel for insurers, in particular, may argue that any contractual requirements for additional insured coverage by subcontractors that requires indemnity or a defense for the active negligence of the general contractor or construction manager are per se unenforceable.

Owners and general contractors may consider greater use of wrap insurance programs for their projects while the process works itself out. In light of 1) the SB 474 amendments, and 2) the inability of owners and general contractors to be able to pass their active negligence on to subcontractors on future projects, it may be advisable for the parties, and general contractors in particular, to seriously explore alternative insuring arrangements such as CCIPs on future commercial projects.

“Type II” indemnity agreements, which allow a party to be indemnified for another party’s passive, as opposed to active, negligence are still legal and enforceable. Passive negligence can include a failure to discover a dangerous condition or a failure by a general contractor to identify a subcontractor’s defective work, among other things.

V. VARIOUS CLAUSES TO WATCH OUT FOR

a. WARRANTIES
b. INSURANCE
c. CLAIMS, DAMAGES AND DISPUTE RESOLUTION
d. MEDIATION AND ARBITRATION
e. DELAY IN TIME EXTENSIONS.
f. NO DAMAGES FOR DELAY
g. NOTICE
h. TERMINATION OR SUSPENSION OF THE CONTRACT
i. CONTRACTORS REVIEW OF DOCUMENTS AND FIELD CONDITIONS.
j. INTEGRATION
k. INTERPRETATION OF CONTRACT DOCUMENTS

VI. PUBLIC WORK ISSUES

A. Pre-Construction Documents

Generally when dealing with any public contract, no single individual (elected or appointed) has the authority to make decisions on behalf of the public body. The public entity can act only through its designated governing body. This situation leads to the contractor being presented with unique considerations when dealing with matters such as the interpretation of the specific contract terms. It is essential that the contract documents clearly reflect the specifications, regulations, statutes and provisions specifically stated or specifically incorporated as set forth in the bid documents. This is true with private work but is especially important in public works contracts.

There are a number of governmental entities within the State of California. The California state agencies are governed by the State Contract Act. (Pub. Contract Code, §§ 10100-19102). Statutes may create contractual provisions not found in the text of a public contract.

The Public Contract Code applies to charter provision or regulation. (Pub. Contract Code, § 1100.7).

Public Contract Code sections 1100 governs general administration in all public contracts.
Public Contract Code sections 10100-19102 governs state agencies.
Public Contract Code sections 20100-22109 governs contracting by local agencies.

In addition to the general statutes, rules and procedures relating to all public contracts, each individual public entity usually will have a set of its own requirements and procedures applicable to construction contracts. Prior to undertaking any work of improvement with any public entity, it is essential to be familiar with the rules and procedures that the public entity applies in the administration of its construction contracts.

The contract must be approved by the governing body of the public entity. The contract may not be legally enforceable if it is not specifically approved. (El Camino Community College Dist. v. Superior Court (1985) 173 Cal.App.3d 606, 219 Cal.Rptr. 236).

B. Bonds

Public Contract Code section 10221 requires that every state public works contract and every county building contract shall provide for the filing of separate performance and payment bonds by the contractor in the form of bonds executed by an admitted surety insurer subject to the approval of the department.

On all works of public improvement other than those undertaken by state entities, a payment bond is required if the project involves in excess of twenty-five thousand dollars ($25,000). (Civ. Code, § 9550).

Architects, engineers and land surveyors are exempt from the bond requirement. Every contractor who is awarded a job in excess of $25,000 must file a payment bond with the California governmental entity that awarded the job. The payment bond must be approved by the public entity (Civ. Code, § 9550). The requirements for such approval are stated in Civil Code section 9554.

Civil Code section 9554 provides, in pertinent part:
In order to be approved, the payment bond shall satisfy all of the following requirements:

(a) The bond shall be in a sum not less than 100% of the total amount payable by terms of the contract.

(b) The bond shall provide that if the original contractor or a subcontractor fails to pay (1) any of the persons named in Section 9100, (2) amounts due under the unemployment insurance code with respect to work or labor performed under the contract or, (3) for any amounts required to be deducted, withheld and paid over to the employment development department . . . that the sureties will pay the same, and also, in case suit is brought upon the bond, a reasonable attorneys fees, to be fixed by the court. The original contractor may require of the subcontractors they bond to indemnify the original contractor for any loss sustained by the original contractor because of any default by the subcontractors under this section.

(c) The bond shall, by its terms, inure to the benefit of any of the persons named in Section 9100 so as to give a right of action to those persons or their assigns in any suit brought upon the bond.

(d) The bond shall be in a form of a bond and not in deposit in lieu of a bond.

The payment bond is for the benefit of all persons named in Civil Code section 9100, which identifies persons may file stop notices.

Each subcontractor submitting bids to a prime contractor must be prepared to submit a payment bond if so requested by the prime contractor. The performance bond must be in a sum equal to at least one-half of the contract price and guarantee the faithful performance of the contract by the contractor. The contract performance bond becomes a part of the contract and to that contract the sureties become parties.

In Golden State Boring & Pipe Jacking, Inc. v. Orange County Water District (2006) 143 Cal.App.4th 718, the Court stated that the general contractor had the right to insist on a performance bond where the subcontractor had imposed the requirement upon itself as consideration for acceptance of a bid. In this case, the subcontractor Golden State Boring & Pipe Jacking, Inc. had submitted a bid to Colich Construction for work to be performed on an Orange County Water District project. In its bid, Golden State stated that it would provide a bond if required even though the request for bid by Colich had not stated a bond would be required. After Orange County Water District awarded the contract to it, Colich requested Golden State to provide a performance bond. Golden State persistently refused to sign the subcontract requiring it to obtain a performance bond as Golden State had gratuitously offered to do in its successful bid for the subcontract. The impasse led Colich to seek the Water District’s approval of its request to substitute Golden State out of participation in the project. After an evidentiary hearing, the Water District authorized the substitution finding that Golden State had refused to execute a written subcontract for the scope of work specified in its bid.

Golden State argued that the general contractor had no right to insist on a performance bond because the general contractor had failed to make a statutory request for bond under Public Contract Code section 4108. That argument was rejected by the Appeals Court. The Court found that because even if Colich had not made a written or published request for a bond in its request for bids, it was not barred from accepting the gratuitous proposal of the subcontractor to provide a bond. The Court found that Public Contract Code section 4108 was inapplicable.

C. Notice to Proceed

The basic public works contract usually establishes a time for commencement and completion of the work. The time for performance is generally stated in days from commencement to the date by which the work must be substantially completed. It is usually stated in calendar days in order to avoid any disagreement over how to count holidays and weekends. It may also have a reference to a specific date.

Most public works contracts contain a provision that states “time is of the essence.” The legal significance is generally tied to a provision for liquidated damages. Liquidated damages are a fixed amount set by contract, to quantify compensation due to inexcusable delays. The duty and responsibility of interpreting the requirements of the contract documents will generally be assigned to the owner’s representative in charge of administering the project. If an architect who was involved in the design of the particular project is involved in deciding whether a particular detail should have been included as an element of the design or left to the contractor’s discretion, clearly the architect will follow its own best interests.

Public contracts will incorporate specific standardized specifications and refer to statutes, administrative codes, procedural manuals, regulations and other documents which explain or influence interpretation of plans, specifications or contract paragraphs. All incorporated statutes, etc. must be examined to determine their effect.

D. Change Orders

A public works contract can be modified only through an approved change order. The change order procedure should not be used to change the scope of work at the project without complying with the bidding procedure.

Construction change orders arise from specific actions taken by any one of the many participants in a construction project. These actions may be caused by many varied factors which exist on every construction project. Change orders may arise from specific physical circumstances, failures by individuals to account for work required by the project requirements and so on and so on.

1. Directed Changes

Most public works construction contracts contain a change order clause permitting the public entity to unilaterally require the contractor to perform changes in work that increase or decrease the contract price. Such clauses allow the owner to add or delete work from the project without stopping the progress of the work, pending processing of a change order to the contract, or even resolution of a dispute in the courts. In absence of such a provision, under normal contract law, a contractor could sue for breach of contract if the public entity made significant additions to, or deletions from, the work originally contemplated at the time the contract was made.

2. Constructive Changes

A constructive change generally arises when the public entity directs the contractor to perform work that the public entity, but not the contractor, considers to be within the original scope of work required to be performed under their contract. A constructive change has been described as follows:

Each of the other elements of the standard “changes” or “extras” clause has been present – the contracting officer has the contractual authority unilaterally to alter the contractor’s duties under the agreement; the contractor’s performance requirements are enlarged; and the additional work is not volunteered but results from a direction of the governments officers.

(Landco & Associates v. United States (1967) 385 F.2d 438.) For state contracts, Public Contract Code section 10251 provides that provisions for the performance of extra work and the furnishing of materials therefor may be inserted in the contract to insure the proper completion or construction of the whole work contemplated provided that bidders have an equal opportunity of knowing the proposed terms for the extra work.

Public Contract Code sections 20136, 20139, 20142-20143 and 20145 control the extra work provisions of county contracts.

Extensive and excessive change orders by an owner may constitute an abandonment of the project by the owner and subject the owner to damages based on the theory of quantum meruit in private work construction. In the specific context of construction contracts, when an owner imposes on the contractor an excessive number of changes the scope of work under the original contract has been altered. When a construction contract has been abandoned, the contractor who completes the project is entitled to recover the reasonable value of its services on a quantum meruit basis (C. Norman Peterson Co. vs. Container Corp. of America (1985) 172 Cal.App.3d 628, 640, 218 Cal.Rptr. 592.) The California Supreme Court rejected the abandonment theory and held it did not apply to public works contracts. (Amelco Electric vs. City of Thousand Oaks (2002) 27 Cal.App.4th 228.)

E. Payment Procedure

Public entity contracts of a minimum threshold amount must require that a portion of the contract price be retained by the public entity to satisfy project claims, pending final completion of the contract and an evaluation of the contractor’s performance (see, for example, Pub. Contract Code, § 10379). Many public entities provide for additional retentions in their own contract documents by virtue of practice, charter provisions, or resolution. Public Contract Code section 7102 provides that contract provisions in public construction contracts and subcontracts that limit the contractee’s liability to an extension of time for delay for which the contractee is responsible, and which is unreasonable under the circumstances and not within the contemplation of the parties, shall not be construed to preclude the recovery of damages by the contractor or subcontractor. No public agency may require the waiver, alteration, or limitation of the applicability of these provisions and that any such purported waiver, alteration, or limitation is void.

F. Problems

Some of the typical problems in public work construction are:

1. Defective plans and specifications
2. As built conditions
3. Failure to make payment
4. Delay
5. Interference with the contractor’s performance
6. Failure to approve and process change orders and change order requests
7. Scope of work issues

Often the conduct may not rise to the level of a “breach” of contract, and, as a result, the contractor will present its claim in a request for change order for any additional costs or time impact that the contractor has suffered as a result of improper conduct by the owner.

Defective Plans and Specifications

The courts have long held that damages for defective plans and specifications are recoverable. Generally, the measure of damages is the increased cost of labor and materials necessary to overcome the defect in the plans and specifications.

The general rule was set forth in Tonkin Construction Co. vs. County of Humbolt: The court stated the rule for establishing a public entity’s liability as follows: The rule establishing a public entity’s liability for misrepresentation was set forth by our Supreme Court in Souza & McCue Constr. Co. v. Superior Court, supra, 57 Cal.2d at pages 510-511: (3) “A contractor of public works who, acting reasonably, is misled by incorrect plans and specifications issued by the public authorities as the basis for bids and who, as a result, submits a bid which is lower than he would have otherwise made may recover in a contract action for extra work or expenses necessitated by the conditions being other than as represented.

[Citations omitted.] This rule is mainly based on the theory that the furnishing of misleading plans and specifications by the public body which constitutes a breach of an implied warranty of their correctness. (See also Warner Constr. Corp. v. City of Los Angeles (1970) 2 Cal.3d 285, 293-294 [84 Cal.Rptr. 444, 466 P.2d 996]; Welch v. State of California (1983) 139 Cal.App.3d 546, 550 [188 Cal.Rptr. 726].) (Tonkin Construction Co. v. County of Humbolt (1987) 188 Cal.App.3d 828, 832.)

In City of Salinas v. Souza & McCue, the California Supreme Court stated the applicable law when a public agency fails to disclose information relevant to the performance of a contract:

It is the general rule that by failing to impart its knowledge of difficulties to be encountered on a project, the owner will be liable for misrepresentation if the contractor is unable to perform according to the contract provisions . . . A contractor of public works who, acting reasonably, is misled by incorrect plans and specifications issued by the public authorities as the basis for bids and who, as a result, submits a bid which is lower than he would have otherwise made may recover in a contract action for extra work or expenses necessitated by the conditions being other than as represented. [Citations omitted.] This rule is mainly based on the theory that the furnishing of misleading plans and specifications by the public body constitutes a breach of an implied warranty of their correctness. [Citations omitted]. (City of Salinas vs. Souza & McCue (1967) 66 Cal.2d 217.)

If the contractor constructs a project in accordance with the plans and specifications and the finished product is defective, the contractor will most likely not be liable. However, that even though the contractor installs work in accordance with the plans and specifications, the contractor may still be held liable for any damages caused if it violates industry standards in installing the work.

The public entity will attempt to shift the risk of loss to the contractor by including disclaimers or clauses in the contract documents requiring contractor to notify the entity of any “problems” with plans, site conditions, etc. If the owner inserts a very specific clause that clearly and definitely shifts the risk to the contractor, it will be upheld.

Obligation of Contractor to Proceed with the Work

A question that often arises is whether the contractor is obligated to proceed if the public entity will not grant a change order for additional time and money. There is no easy answer to this question. The contractor has two options: it may continue performance under protest, while reserving the right to claim additional compensation, delay damages, and extensions of time or acceleration damages; or it may cease performance, contending that the refusal to grant a change order is a breach of contract excusing the contractor’s further performance. Each case must be analyzed on its own facts. In some cases, if the problem crated by the errors and omissions in the plans and specifications is a “material” change, then the contractor can cease performance.  On the other hand, if the problem is “minor” or “trivial,” the contractor must continue to perform. If the contract contains a clause requiring the contractor to continue to perform disputed work, the contractor must do so.

G. Default

Default is often used and frequently misunderstood. The term “default” although having special meanings is usually defined in the contract it relates to specific types of situations that constitute a default. An example would be that a contractor defaults if it files for bankruptcy protection. A more difficult situation occurs when a default involves a subjective determination such as contractor is proceeding in an untimely manner.

A breach in a construction contract does not necessarily constitute a default. It is generally held that to trigger a default of the contract (and possibility liability of the surety), that the default must both exist and be a material breach of the contract. The existence of a material breach of contract is more difficult to determine than the existence of a breach. For a breach of contract to give rise to a default, it must be material to the contract and have sufficient magnitude to justify demand or declaration of default if it is not a specific type of breach specifically identified in the contract as a default.

The materiality of a breach must be determined by a fact finder or jury. In Federal Insurance Co. v. Superior Court (Mackey) (1998) 60 Cal.App.4th 1370, the court addressed a case which involved a dispute between a subcontractor and a prime contractor on a public works project under a payment bond. The subcontractor sued the general contractor and the payment bond surety to collect money allegedly owed on a project. The general contractor made the demand for arbitration and request to stay the action pending arbitration. The trial court ordered a stay of the subcontractor’s action against the general but did not stay the action against the surety. The surety appealed the failure to stay because it asserted issues to be decided in the arbitration were pivotal to the action against the surety.

The court ruled that the surety’s liability under the bond would rise only if the contractor failed to pay “work performed under the contract.” The demand for payment for labor and materials furnished at the project laid at the heart of the proceeding against the surety. The demand for payment necessarily involved determination as to whether the subcontractor is entitled to be paid for the labor and materials. The subcontractor must prove that he performed under the contract and that the general contractor did not perform.

H. Stop Notices

Public entities are frequently presented with stop notices relative to both large and small construction projects. The stop notice is authorized by Civil Code section 9100 which allows subcontractors, material suppliers and other persons involved in construction projects to freeze construction funds in order to ultimately satisfy their claim if and when it is finally ruled upon in court or otherwise resolved.

The stop notice, while also available in private works, is important on public projects because the mechanics’ lien remedy is not available for the public property claimant. Civil Code section 9100 permits any person who would be entitled to a mechanic’s lien, to file a stop notice in order to project a claim against withheld funds in connection with the public construction project. A stop notice claimant (other than a laborer for wages or an express trust fund) who had no direct contractual relationship with the contractor must give the preliminary 20-day notice as a mandatory prerequisite. (Civ. Code, § 9300).

The stop notice itself must contain (Civ. Code, §§ 9302 and 9303):

(1) the claimant’s name and address.
(2) The kind of labor, services, equipment or materials furnished or agreed to be furnished by the claimant.
(3) the name of the person to or for whom the same were done or furnished.
(4) the amount in value of work and materials already done or furnished by the claimant.
(5) the total amount in value of all work and materials agreed to be done or furnished by the claimant.
(6) a signature and verification by the claimant or his agent.

The public works stop notice must be served upon the public entity responsible for the public work within 30 days after the recording of a notice of completion (notice of acceptance) or notice of cessation of labor (if such notice is recorded). If no notice of completion or notice of cessation is recorded, the stop notice must be served within 90 days after actual completion of cessation. (Civ. Code, § 9356). The date of completion of a public work of improvement is the date of acceptance by the public entity. (Civ. Code, § 9200).

Civil Code section 9354 provides that the notice shall be filed with the director of the department which let the contract for the work in the case of work for the State of California. In the case of any other public work, the stop notice shall be filed in the office of the public officer whose duty it is to make payments under the provisions of the contract, or with the body by whom the contract was awarded. It is important to serve the stop notice on the correct individual within the entity who has this responsibility in order to ensure timely processing. Stop notice requirements are strictly construed by the courts. (A.J. Setting Co. v. Trustees of Cal. State University and Colleges (1981) 119 Cal.App. 374).

A recent decision by the California Court of Appeal discussed an issue which has begun to arise more and more often. This issue is if a public entity leases land to a private company who improves the public property but does not pay the contractor for the improvement may that contractor record a mechanic’s lien.

In North Bay Construction, Inc. v. City of Petaluma 143 Cal.App.4th 552, North Bay Construction sought to recover from the City of Petaluma for grading work it performed on city land under a contract with a developer to whom the city had leased the property. North Bay sought to foreclose a mechanic’s lien against the property and to obtain judgment against the City on the quasi-contractual theory of quantum meruit. The trial court dismissed North Bay’s complaint on the grounds that a mechanic’s lien cannot be enforced against property owned by a municipality, even if the work was not performed as part of a “public work” project and a contractor cannot recover in quantum meruit for improvements to a municipality’s property performed under a contract with a third party. The Court of Appeal, quoting a California Supreme Court decision from 1891, Mayrhofer v. Board of Education (1891) 89 Cal. 110, 112, found that publically-owned property is immune from liens for labor or supplies.

It has long been true that a quasi-contract theory cannot be asserted against a municipality in a public works context. (Amelco Electric v. City of Thousand Oaks (2002) 27 Cal.4th 228,239.)

I. Final Payment

Public Contract Code section 7102 provides that contract provisions in public construction contracts and subcontracts that limit the contractee’s liability to an extension of time for delay for which the contractee is responsible, and which is unreasonable under the circumstances and not within the contemplation of the parties, shall not be construed to preclude the recovery of damages by the contractor or subcontractor. This section was amended effective January 1, 1988, to specify that no public agency may require the waiver, alteration, or limitation of the applicability of these provisions and that any such purported waiver, alteration, or limitation is void.

Public Contract Code section 20104 et seq. now provides for a process utilizing informal conferences, nonbinding, judicially supervised mediation, and judicial arbitration to resolve construction claims of $375,000 or less. Public agencies incorporate provisions in their contracts implementing these mandatory provisions for any work that could give rise to such a claim.

J. Prompt Payment Statutes

Public Contract Code section 7107 requires that for any public works contract, all retentions must be released within 60 days after completion of the project. “Completion” is defined as: (1) occupation, beneficial use, and enjoyment of the work of improvement; (2) the acceptance of a work of improvement; (3) a cessation of labor on the work of improvement for a continuous period of 100 days; or (4) a cessation of labor for a continuous period of 30 days if the public agency records a notice of cessation or a notice of completion. Under the statute, the public agency may withhold from the final payment ana mount not to exceed 150 percent of any disputed payment.

In the case of state agencies which retain less than 125 percent of the estimated value of the work yet to be completed, the state agency may take up to 90 days to release undisputed funds.

A two percent per month charge in lieu of interest can be collected for violations of this section. A surety is liable also for an interest penalty imposed by Public Contract Code section 10262.5. In addition, in actions brought pursuant to this section, the prevailing party can recovery attorney’s fees. This means, also, that if the contractor loses the prompt payment claim, it can be held responsible for the public entity’s attorney fees. Thompson Pacific Construction v. City of Sunnyvale (2007) 155 Cal.App.4th 525. Capitol Steel Fabricators, Inc. v. Mega Construction Co. (1997) 58 Cal.App.4th 1049, 68 Cal.Rptr.2d 672 held that a “pay when paid” clause was not enforceable against a subcontractor in a public works contract.

The issue in Capitol Fabricators was whether the pay when paid provision in that case remained enforceable because, due to the principle of sovereign immunity, laborers and material suppliers on public works are protected in the stop notice and public payment bond statutes rather than by a mechanic’s lien under the California Constitution.

Public Contract Code section 10262.5, which is incorporated by law into all public works construction subcontracts, provides that the prime contractor’s failure to pay a subcontractor within 10 days of receipt of each progress or retention payment subjects the prime contractor to a “penalty” of 2 percent interest per month on any amounts unpaid after the 10-day period. Section 10262.5 also allows subcontractors to recover the attorney fees and costs they incur collecting any wrongfully withheld payments.

K. Dispute Resolution

Initially, the general or special conditions of a construction contract may contain a preliminary claims procedure. It is unusual to find a contract which does not have some type of alternative dispute resolution procedure set forth in the specifications. These types of dispute resolution procedures, in general, will require the parties to engage in trying to resolve the dispute with a type of dispute resolution procedure. The procedure often involves a neutral third party to provide assistance. The use of a third party neutral is commonplace after work is completed. The “partnering” which is often done at the beginning of a project is a method of dispute resolution. Other such procedures include mediation, arbitration, etc.

However, some public construction contracts require claims of a certain amount to be arbitrated. Other contracts will require that the claim be submitted to an architect/engineer, whose decision will be final and binding on the parties. Other contracts will have the claim must be submitted to the architect/engineer whose decision is final unless the claim is submitted to arbitration within a specific period of time.

Public works claimants must comply with the claims procedures of Government codes sections 900-996.6 which cover most claims between public entities. In the recent case of City of Stockton, et al. vs. Superior Court (2007) 68 Cal.Rptr.3d 295, the California Supreme Court resolved a split of authority in the Courts of Appeal as to whether the claims presentation requirements of the Government Claims Act apply to construction contract claims. It held that the plain meaning and legislative history of the claims presentation statutes confirm that they were intended to apply to contract claims.

Public Contract Code section 20104 et seq. provides for a process utilizing informal conferences, non-binding, judicially supervised mediation, and judicial arbitration to resolve construction claims of $375,000 or less. Public agencies incorporate provisions in their contracts implementing these mandatory provisions for any work that could give rise to such a claim. It is important that the claim be prepared as thoroughly and completely as possible because it becomes the foundation for pleadings and proof at trial.

L. Bid Protest

Most public entities require a prime bidder to support its bid with bid security in an amount equal to a specified percentage of the bid amount. A prime bidder who wishes to withdraw a bid will often be permitted to do so but only if the bid bond is forfeited. A bidder that submits a mistaken bid may be relieved from the bid by consent of the awarding authority or may bring an action in superior court to recover the amount of the bond forfeited. The bidder to withdraw its bid must establish under Public Contract Code section 5103 that:

(1) A mistake was made;

(2) The bidder gave written notice to the public entity within five days after the bid opening specifying the mistake; and

(3) The mistake was material and not due to an error in judgment. Most competitive bidding statutes give the awarding authority discretion to retract all bids and to re-advertise. When a public entity reserves the right to reject all bids, Government Code sections 815.2 and 820.2 bar actions by a rejected low bidder even when the rejection is negligent.

Competitive bidding statutes usually provide that the contract will be awarded to the lowest responsible and responsive bidder. Public Contract Code section 1103 defines responsible bidder as a bidder who has demonstrated the attributes of trustworthiness as well as quality, fitness, capacity and experience to satisfactorily perform a public works contract.

The discretion to reject the low bid will not be interfered with in the absence of fraud or abuse. (West v. City of Oakland (1916) 30 Cal.App. 556.) The standard of review is the substantial evidence test. If the public entity’s decision to reject a bid is not arbitrary, capricious and entirely lacking in evidentiary support or procedurally deficient it will be upheld. (Associated Builders & Contractors v. San Francisco Airports Commission (1999) 21 Cal.4th 352.)

An agency that rejects the low bid must conduct a hearing and make a specific finding that the low bidder is not responsible. (City of Inglewood v. Superior Court (1972) 7 Cal.3d 861.) A public entity has no power to reject a low bid on the ground that another bidder is more responsible. Rejection of a low bid must be based on a determination that the low bidder is not responsible.

In Kajima/Ray Wilson v. Los Angeles County Metro Transit Authority (2000) 23 Cal.4th 305, the California Supreme Court stated that when a public agency solicits bids, it represents, consistent with the statutory mandate, that if the contract is awarded it will be awarded to the lowest responsible bidder. However, the court reversed an award of lost profits on public policy grounds holding that the disappointed low bidder was entitled to recover bid preparation expenses and bid protest expenses but not anticipated profit.

M. Disputed Stop Notices; Release Bond And/or Summary Release Proceedings

If the stop notice is disputed, the original contractor or subcontractor may either file a release bond or the original contractor may utilize the summary proceedings procedure. N. Release Bond Civil Code section 9364 provides that the public entity may permit the original contractor to file with the public entity a corporate surety bond in an amount equal to 125 percent of the claim stated in the stop notice. The existence of this bond protects the claimant in that it, in essence, substitutes the surety for the funds withheld.

O. Summary Proceedings

If the original contractor disputes the stop notice claimant’s right to have the public entity withhold money from the general contractor, a summary proceedings to resolve the withhold issue is available.

The procedure is as follows:

(1) The contractor serves the public entity with an affidavit stating the legal grounds upon which the claimant alleges the stop notice should be ineffective and demanding the release of all or such portion of such money. (Civ. Code, § 9402.)

(2) The public entity then must serve upon the stop notice claimant a copy of the affidavit and a demand for the release together with a written notice stating that the public entity will release the money, unless the claimant files with the public entity a counter affidavit, not less than 10 days nor more than 20 days after service upon the claimant of the affidavit. (Civ. Code, § 9404.)

(3) The stop notice claimant then must file and serve the counter affidavit with the public entity within the time allotted, stating in his counter affidavit in detail the specific basis upon which he contests or rebuts the allegation of the original contractor’s affidavit. (Civ. Code, § 9406.)

(4) If the stop notice claimant files the counter affidavit with the proof of service, either he or the original contractor may file an action in the superior court for a declaration of the rights of the parties. A hearing must be granted by the court within 15 days after a motion is made by either the original contractor or the claimant for such hearing. The public entity must be notified of the hearing by the moving party not less than five days prior to the hearing. (Civ. Code, § 9408.) The burden of proof is on the original contractor at the hearing. (Civ. Code, § 9410.) The court may order the hearing continued for the production of other evidence or make its determination on the affidavits. The right to a jury trial is preserved by Civil Code section 9414. When the hearing is concluded, the court must enter its order determining whether the demand for release shall be allowed or not. The original contractor must serve a copy of the order on the public entity. (Civ. Code, § 9412.)

P. Enforcement of Stop Notice

An action to enforce a stop notice may be filed any time after ten days from the date of service of the stop notice upon the public entity. However, the action must be commenced not later than 90 days following the expiration of the period within which stop notice must be filed as provided in Section 9356.

Public entities must give notice that a notice of completion has been filed or cessation of labor is deemed a completion within ten (10) days of such event to all stop notice claimants who have paid the public entity two dollars ($2) at the time of the filing of the stop notice pursuant to Civil Code section 9362.

A public entity is under a mandatory duty to withhold funds pursuant to a valid and timely stop notice. (United States Fidelity and Guaranty Co. v. Oak Grove Union School District (1962) 205 Cal.App.2d 226, 22 Cal.Rptr. 907.) However, if no action is commenced in a proper court within such ninety day period, the public entity must release the funds withheld. The filing of a complaint to foreclose on a stop notice is accomplished by:

a. File suit on the stop notice in the proper court. This means in superior court in the county where the work of improvement lies.

b. The attorney must commence the action no sooner than ten days after service of the stop notice and no later than the 90-day period following the expiration of the time during which stop notices could be filed.

c. Notice must be given to the public entity for which public improvement is being constructed within five (5) days after commencing the action by personal service, registered or certified mail.

d. The attorney must bring the action to trial within two (2) years of its commencement or face discretionary dismissal by the court.

e. These procedural requirements are strictly construed by the courts.

Q. Payment Bond Enforcement

To enforce a claimant’s right under a payment bond on a public works project, the attorney must:

a. Cause to be served on the owner (public entity) and the original contractor with whom the claimant has contracted a 20-day preliminary notice. Claimants who fail to timely give notice may still make a claim against a payment bond if they give written notice to the principal and the surety on the bond within fifteen (15) days after recordation of a notice of completion or, if no notice of completion has been recorded within seventy-five (75) days after completion of the work of improvement. (Civ. Code, § 9560).

b. Complaint must be filed in the proper court on the payment bond. The proper court is the superior or municipal or justice court in the county where the public works project is situated, depending upon the amount of the claim, if the action on the bond is combined with the action on the stop notice. (See §§ 6.18 and 6.19, infra). If action is only on the payment bond, the plaintiff has other venue options. Filing a stop notice is not a condition precedent to maintaining an action on a stationary payment bond. (Civ. Code, § 9564).

c. The attorney must file the suit prior to the expiration of six month after the period in which stop notices must be filed. The commencement of suit prior to the time that the claimant has furnished the last of his labor or materials is premature. (Civ. Code, § 9558).

Civil Code section 9564(c) expressly provides that in any payment bond action, the court shall award to the prevailing party a reasonable attorney fee, to be taxed as costs. Attorney fees are recoverable in arbitration proceedings as well as litigation. (Liton General Engineering

Contractor, Inc. v. United Pacific Insurance (1993) 16 Cal.App.4th 577.) In determining what constitutes a reasonable attorney fee, courts should consider the nature of the litigation, its difficulty, the amount involved, the skill required, the success of the attorney’s efforts, his/or learning, age, and experience in the particular type of work demanded, the intricacies and importance of the litigation, the labor and necessity for skilled legal training and ability in trying the cause, and the time consumed. (Contractors Labor Pool, Inc. v. Westway Contractors, Inc. (1997) 53 Cal.App.4th 152, 61 Cal.Rptr.2d 715.)

VII. PRIVATE WORK ISSUES

The most important changes to California construction law in decades will become effective on July 1, 2012. Signed into law in 2010, Senate Bill 189, reorganized and renumbered all those California Civil Code provisions dealing with such familiar construction claim remedies as the Mechanics Lien, Stop Notice and Bond Claim. These changes include new definitions, new rules and new procedures found in new Civil Code Sections 8000 to 9566. These changes also mean that new forms will be necessary. As a result of these changes, all those in the construction industry should begin using the new forms and procedures beginning on July 1, 2012. A website to access the new forms free of charge is also identified below.

Changes to Construction Forms Generally:
Beginning on July 1, 2012, the following forms must be discarded and new forms used:The “Preliminary 20 Day Notice” (both public and private), the four “Conditional” and “Unconditional” Releases on “Progress Payment” and “Final Payment,” the “Mechanics Lien,” the “Release of Mechanics Lien,” the “Stop Notice,” “Release of Stop Notice” and “Notice of Completion.” All of the new forms, updated to include all legal changes as of July 1, 2012 are available at the following website at no charge: http://www.porterlaw.com/forms.htm.

The Preliminary Notice:

The document the construction industry has known for decades as the “Preliminary 20 Day Notice” has a new title. Although it should still be served within 20 days after first providing work or materials to a project, it is now simply called the “Preliminary Notice.” In addition to hand delivery and certified or registered mail, the Preliminary Notice can now be served by overnight delivery by an express mail carrier or in the same manner in which a summons and complaint is served in a civil action. The language of the “Notice” section at the top of the private works Preliminary Notice has also changed. The Preliminary Notice must also now describe “the relationship to the parties of the person giving the notice,” meaning that the claimant must generally state whether they are a contractor, subcontractor or material supplier in relation to those served. Also, unlike previously, the public Preliminary Notice must now provide an “estimate of the total price of the work provided and to be provided.”

Conditional and Unconditional Waiver and Releases on Progress and Final Payment:

Each of the four traditional forms (The “Conditional Waiver and Release on Progress Payment,” the “Unconditional Waiver and Release on Progress Payment,” the “Conditional Waiver and Release on Final Payment,” and the “Unconditional Waiver and Release on Final Payment”) has been changed at least slightly. The most significant change is that the Conditional Waiver and Release on Progress Payment allows the exclusion from the waiver and release as to sums for which the claimant has given a prior Conditional Waiver and Release but for which payment has not been received.

Mechanics Lien:

The Mechanics Lien Form has also changed. However, the changes for 2012 are only slight. The major changes to the Mechanics Lien form took effect at the beginning of 2011 and include an important new notice provision and new service requirements.

Stop Payment Notice:

The Stop Notice Form has also changed. To provide greater clarity and distinguish itself from the “Stop Work Notice” the Stop Notice is now more accurately deemed the “Stop Payment Notice.” Like the new Preliminary Notice, the new Stop Payment Notice may now be served by overnight delivery by an express mail carrier or in the same manner in which a summons and complaint is served in a civil action. Unlike the Prior Stop Notice the new Stop Payment Notice must be served on the “direct contractor” (previously termed the “original contractor”) as well as the owner or reputed owner and the lender, if any.

Payment Bond Notice:

The Payment Bond Notice may now be served the same as the above forms, that is by personal service or by registered or certified mail, but also now by overnight delivery by an express mail carrier or in the same manner in which a summons and complaint is served in a civil action. The major change though was as a result of a companion Bill to SB 189, SB 293. Under prior law a potential Payment Bond claimant who failed to properly serve a Preliminary 20 Day Notice could still successfully make a claim on a Payment Bond if the claimant served a Payment Bond Notice within 15 days of a Notice of Completion or 75 days from actual completion (if there was no Notice of Completion). Serving the Payment Bond Notice would “cure” the failure to properly serve the Preliminary 20 Day Notice for those seeking to make a claim on the Payment Bond. SB 293 changes this.


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