On April 1, 2015, in East West Bank v. Rio School District, the Second Appellate District of the California Court of Appeal held that whereas under Public Contract Code § 7107, a public entity can withhold funds owed to a contractor when there are liens on the property or when there is a good faith dispute concerning whether the work was properly performed, the public entity cannot withhold funds due to a contractor over a dispute over the contract price. In reaching its holding, the court noted its disagreement with Martin Brothers Construction, Inc. v. Thompson Pacific which held otherwise. The Court also held that the doctrine of “unclean hands” does not apply to Public Contract Code § 7107, to limit a contractor’s potential recovery of damages and attorney’s fees. Finally, the Court held that the time limitations for a contractor to submit a claim under a public works contract do not apply where that contractor’s claims arise out of the public entity’s alleged breach of that contract.

Background Facts

In East West Bank, the Rio School District (District) entered into a contract with FTR International, Inc. (FTR) to build a school. During construction, FTR submitted approximately 150 proposed change orders (PCOs), asserting that they were necessary due to the District providing plans that were inadequate and misleading. The District, however, denied most of the PCOs on the grounds that the work was covered under the base contract, that the amounts sought by FTR were excessive, and/or on the grounds that a given PCO was untimely in accordance with the public works contract notice provisions. The project was ultimately completed in June 2001 and the District filed a notice of completion on August 7, 2001.

Thereafter, a dispute between FTR and the District arose out of a payment issue. Under the contract, the District retained 10% of each progress payment, such that at the completion of all work, the District held a reserve of $676,436.49. The reserve was subject to stop notices filed by FTR’s subcontractors until the last stop notice was released on September 28, 2004. When the District failed to pay the balance due under the contract, refused to release any of the retention, and refused to compensate FTR for delay and disruption damages, FTR filed suit. FTR asserted a claim against the District for breach of contract and violation of Public Contract Code § 7107, seeking damages, statutory penalties, attorney’s fees, interest and costs. The District countered with a separate lawsuit, which was subsequently consolidated. After the trial court found in FTR’s favor, the District appealed, raising three primary issues regarding when a public entity can withhold retention payments under Public Contract Code § 7107, whether a contractor must comply with time limitations for filing a claim under a public works contract following a breach, and whether a public entity can assert an “unclean hands” defense to dispose of a claim for damages and attorney’s fees following a statutory violation.

Explanation of the Court’s Decision

A. Pubic Contract Code § 7107 Penalties

In reaching its decision, the Second Appellate District noted that Public Contract Code § 7107(c) calls for a public entity to release any retention previously withheld within 60 days after completion of a work of improvement. In the event of a dispute, the public entity can withhold from the final payment an amount not to exceed 150% of the disputed amount. Under subsection (f), however, a public entity will be subject to a penalty of 2% per month, in lieu of interest, on any contract amount improperly withheld, plus attorney fees and costs. At trial, the District argued that it was justified in withholding the retention amount – more than 10 years after completion of the project – due a good faith dispute with FTR over whether a majority of the 150 PCOs were wrongfully denied, which the District claimed, impacted how much money, if any, it owed FTR. The Court found that argument unavailing. It noted that the purpose of retention is to provide security against potential mechanics liens and to insure that the contractor will complete its scope of work properly and repair any defects. The Court added that once the public entity no longer needs that security, the retention funds must be paid. Since the dispute with FTR for additional monies did not require the District to retain funds as security, the District’s failure to pay is exactly the type of behavior that Public Contract Code § 7107 was enacted to deter. Thus, the Court found that the District was subject to the statutory penalty.

B. Public Contract Notice Provisions vs. Public Entity’s Breach of Contract

Next, the Second Appellate District in East West Bank addressed the issue of whether a contractor can recover damages on claims that are not submitted within the time limits set forth under a public works contract. On this issue, the Court found that some of FTR’s claims arose from the District’s breach of the contract, in not providing adequate plans and specifications. As a result, the Court – relying on a seldom-used 1959 decision inD.A. Parrish & Sons v. County Sanitation Dist., etc. -- held that the time limitations in a public contract do not apply to claims arising from the public entity’s alleged breach of that contract.

C. Prejudgment Interest on Liquidated & Unliquidated Damages

In addition to holding that FTR could still seek recovery for damages arising out of the District’s decision to withhold retention payments under Public Contract Code § 7107(c) and damages for the District’s breach of the contract, the Second Appellate District also held that FTR could seek an award of prejudgment interest. Civil Code § 3287(a) provides that a person entitled to recover damages certain can also recover interest from the date that the right of recovery vests. In addition, under Civil Code § 3287(b) any person entitled to damages on a contract claim, even where the claim is unliquidated, may also recover interest from a date prior to the entry of final judgment, as the court, in its discretion, may award. In this instance, the trial court had calculated the amounts unpaid to FTR on the contract after the notice of completion, minus certain credits and minus those amounts subject to a penalty in lieu of interest under the Public Contract Code, before settling on an award of liquidated prejudgment interest under Civil Code § 3287(a).

The Second Appellate District also found that the trial court did not abuse it discretion when awarding additional prejudgment interest to FTR for unliquidated damages under Civil Code § 3287(b), based on 25 PCOs as of the date of the project’s completion. Even though the amount of prejudgment interest exceeded the amount FTR sought on those PCOs, the Court dismissed the District’s arguments given the District’s failure to pay the damages more than 10 years earlier. The Court acknowledged that the amount of prejudgment interest may have to be adjusted for any PCOs found to be untimely under the contract notice provisions, but otherwise affirmed the amounts awarded to FTR – further highlighting the ramifications for the District’s actions toward FTR.

D. The “Unclean Hands” Defense & Availability of Attorney’s Fees Awards

The Second Appellate District in East West Bank concluded with a discussion regarding whether a public entity can assert an “unclean hands” defense to FTR’s claim for damages, penalties and attorney’s fees under Public Contract Code § 7107. Reviewing the purpose behind the code section, the Court noted that when the California Legislature enacts a statute forbidding certain conduct for the purpose of protecting one class of persons from the activities of another, a member of the protected class can maintain an action for a violation of that statute, notwithstanding the fact that the plaintiff shared in the illegal transaction. The Court added that the protective purpose of the legislation is only realized by allowing the plaintiff to maintain an action against the defendant within the class that is to be deterred.

In this instance, Public Contract Code § 7107 was intended to protect one class of persons (public works contractors) from the activities of public entities. As a result, the doctrine of “unclean hands” does not apply a matter of law, and FTR (as a member of the protected class) can recover attorney’s fees, in addition to all other damages available as a result of the District’s violation of the statute.

Takeaways

All told, the East West Bank case is great news for contractors on public works contracts. A public entity cannot withhold retention from contactors on projects involving a payment or contract dispute, in the absence of a mechanics lien, a stop notice, or a claim of defective work. Particularly where a payment dispute can take years to resolve through litigation, this case is a reminder that public entities cannot hold onto retention amounts as a means of placing economic pressure on the complaining contractor. Where the public entity engages in that behavior, it may be liable to the contractor for damages, attorney’s fees and penalties under Public Contract Code § 7107, in addition to prejudgment interest. Moreover, the public entity will not be able to assert an “unclean hands” defense to reduce or eliminate an award in the contractor’s favor – great news for contractors going forward.

The East West Bank decision, however, also highlights a split of authority between the California Courts of Appeal regarding whether a contractor will have waived a claim for damages and extra compensation under the (typically) harsh notice provisions in public works contracts. In this instance the Court held that District’s breach of the contract disposed of the notice requirements – a rare victory for a contractor under these circumstances. In many instances, courts have would have foreclosed any recovery for FTR’s claims for extra compensation. In fact the Court reiterated several times that public entities, by statute, are permitted to include notice provisions in public works contracts that give the government entity the opportunity to quickly investigate and settle claims – even if the clauses appear to be one–sided or borderline unconscionable – as means for the public entity to keep track of additional expenses. Indeed, the increasing presence of harsh notice provisions remains the trend in public works contracts. Thus it is very important for contractors on public works projects to comply with the notice provisions – despite this recent decision -- or else risk forfeiture.