Prompt Payment Laws

 WITHHOLDING UNDER PROMPT PAYMENT LAWS MUST BE OBJECTIVELY REASONABLE

The timing of construction payments in California is regulated by a series of laws that are collectively called the “prompt payment laws.”  The particulars of each of the laws are different.   Some apply to public works, some to private; some cover retention payments, others cover progress payments; and some apply to owners, while others apply to contractors.  The common theme of these laws is they require that construction payments be made within a set period of time (e.g. prime contractors must make progress payments to subcontractors within 10 days after receipt of funds from the owner) and impose a penalty (in some cases as high as 2% per month) on late payments.  The prompt payment laws typically allow the limited withholding of payments in the event of a “good faith” or “bona fide” dispute between the parties.

The prompt payment laws themselves do not define what is meant by the term “good faith dispute.”  Some have argued that good faith refers to the subjective belief of the person making the payment—as long as the person has an honest belief that the payment is not due, no matter how incorrect that belief may be, the person does not violate the prompt payment law by withholding payment on account of the dispute.  At least one court case has adopted this subjective standard.  The problem with the subjective standard is the difficulty in proving in court the pure heart of the person withholding the payment.

A case decided by the Court of Appeal on April 25, 2011, rejected this subjective standard.  The case, FEI Enterprises v. Yoon (11CDOS 4764), determined that the only way to honor the legislative purpose of the prompt payment law in question—to encourage general contractors to pay their subcontractors timely and provide a remedy for violation—was to apply an objective standard to determine whether a dispute was in good faith.  The test for good faith is whether the justification asserted for non-payment was “legally tenable.”  Put another way, the person withholding the payment must have more than a pure heart; he or she must have an objectively rational basis for not making the payment.

This new case will require owners or contractors considering withholding payments on account of disputes to evaluate and document their positions carefully, or risk prompt payment penalties.  They should consider having their position on the dispute evaluated by an experienced construction lawyer to ensure it is legally tenable.  Of course, it is always important to provide notice of the dispute and an opportunity to cure as required by the contract documents, and to document the basis for the withholding in sufficient detail.  Finally, most prompt payment laws limit the amount that can be withheld (usually no more than 150% of the disputed amount), so careful practice requires an objective evaluation of the value of the dispute and a reasonable withholding that does not exceed the statutory limits.