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WSHB New Case Update: School District’s Wrongful Withholding of Retention Results in Penalties and Attorney’s Fees

January 29, 2015

FTR International, Inc. v. Rio School District. 2015 WL 332176. January 27, 2015

California Court of Appeal, Second District Issues Ruling on School District’s Ability to Withhold Retention From General Contractor, General Contractor’s Compliance With Contractual Notice Provisions for Change Orders, and Whether Proposed Change Orders Can Form the Basis of a California False Claims Act Violation

HOLDING

Pursuant to California Public Contract Code § 7107, a public entity must release retention funds to a general contractor once all stop notices have been released, absent a showing of a need for further security.  In addition, a claim by a general contractor for delays, impacts and additional compensation for change orders does not constitute a “dispute” entitling the public entity to withhold retention from the general contractor.  Lastly, to recover attorney’s fees for a violation of Section 7107, a party can only recover those attorney’s fees relating solely to the cause of action for violation of Section 7107.

With respect to a general contractor’s compliance with the contractual notice provisions in order to perfect a change order or delay claim, a public entity is not required to show any prejudice in asserting that the contractor failed to comply with the contract.

As it pertains to an attempt by a public entity to pursue a claim for violation of the California False Claims Act, the Court of Appeal held that a proposed change order alone did not constitute a “claim” under the False Claims Act.

WHY THIS CASE IS IMPORTANT

In a case that involved the kitchen sink of disputes between a general contractor, FTR International, Inc. (“FTR”), and a public school district, Rio School District (“District”), the Second District Court of Appeal issued a ruling that touches on many aspects of construction disputes in California.  This decision is important to any party involved in public works construction projects in California.  In the published portion of the decision, the Court of Appeal addressed the ability of a public owner to withhold retention funds under California Public Contract Code § 7107 and the penalties assessed (e.g., interest and attorney’s fees) for improperly withholding retention.  

In the unpublished portions of the opinion, the Court of Appeal addressed the contractual notice provisions that a contractor must satisfy in order to perfect a change order claim, the ability of a public owner to assert claims for violations of the California False Claims Act due to the submission of fraudulent change order proposals, and prejudgment interest.  While these portions of the opinion are not published and not citable under California Rules of Court, Rule 8.1105(b), the analysis implemented by the Court of Appeal is supportive of recent decisions and is illustrative of how other courts and/or arbitrators would deal with these same issues.

FACTS OF THE CASE

This litigation pertains to the construction of a public school in Ventura County for the Rio School District.  In 1999, FTR submitted the winning bid in the amount of $7,345,000 to construct a school for the District.  The construction was completed in June 2001 and the District filed a notice of completion on August 7, 2001.  The school has been occupied since May 2001. 

Pursuant to the contract, the District withheld 10 percent of each progress payment as retention.  At the conclusion of the project, the District held a retention amount of $676,436.49.  This amount was subject to multiple stop notices filed by FTR’s subcontractors.  The last stop notice was released on September 28, 2004.  Although all stop notices were released, the District continued to withhold the retention amount from FTR and, at the time of the decision on the appeal, still held that amount.

Throughout the construction of the school, FTR submitted approximately 150 proposed change orders (“PCOs”) on the grounds that the plans and specifications furnished by the District were inadequate and misleading.  FTR also submitted claims for delay and disruption caused by the District.  In response to the PCOs, the District denied most of them on the grounds that the work was covered under the base contract work, the amounts claimed were excessive or that a PCO was not timely submitted under the timing requirements of the contract.

Ultimately, the District refused to pay the balance due under the contract, refused to pay all but a small portion of the PCOs submitted by FTR, refused to release any of the retention amounts, and refused to compensate FTR for any alleged damages for delay and disruption.  Thereafter, FTR sued the District to recover damages for breach of contract, statutory penalties under Public Contract Code § 7107, attorney’s fees, interest and costs.  The District then filed a separate action seeking damages for 416 separate alleged violations of the California False Claims Act.  FTR then cross-complained in the District’s action, alleging that the District violated the Federal Civil Rights Act (42 U.S.C. § 1981).  All actions were consolidated by the trial court.

At the conclusion of a 243 day bench trial and after years of litigation, the trial court found in favor of FTR and awarded FTR $9,356,124.81, which included damages for the balance due under the contract, extra work performed by FTR, delay and disruption caused by the District, statutory penalties pursuant to Section 7107, attorney’s fees, and prejudgment interest and costs.  Of this amount, the trial court awarded FTR attorney’s fees totaling $3,850,000.  The District appealed.

DISCUSSION

A. Public Contract Code § 7107.

A significant portion of the Court of Appeal’s opinion dealt with whether the District was entitled to continue withholding retention monies after the last stop notice was released.  The trial court held that the District had no justification for retaining the funds after the stop notices were released and assessed a 2 percent per month penalty against the District from the date the stop notices were released for a total penalty of $1,537,404.96.  The trial court also awarded FTR attorney’s fees as an additional penalty totaling $3,850,000.  Thus, as a penalty for withholding retention funds of $676,436.49, the trial court awarded FTR a total of $5,387,404.96 under Public Contract Code § 7107.  This case demonstrates the severe penalties a public entity can suffer if it has not justifiably withheld retention monies from the general contractor.

In withholding the retention monies after the stop notices were released, the District took the position that it was entitled to withhold the retention monies because there was a good faith “dispute” between FTR and the District.  The dispute was over whether FTR was legally entitled to recovery of monies for PCO’s and delay claims.  The Court of Appeal rejected this argument, indicating that “[t]he purpose of a retention is to provide security against potential mechanics liens and to insure the contractor will complete the work properly and repair defects.”  The Court of Appeal went on to hold that once the stop notices were released, there was no further justification for the District to continue withholding the retention, stating as follows:

“Here, after the stop notices were cleared, District points to nothing for which security was required.  The dispute on which District relies, FTR’s claim against the District, does not require the District to retain FTR’s funds as security.”

Importantly, in making this decision, the Second District Court of Appeal expressly declined to follow the decision in Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc. (2009) 179 Cal.App.4th 1401, which held that under Public Contract Code § 7107 a general contractor could withhold monies from a subcontractor for “any good faith dispute” between a general contractor and a subcontractor.  Thus, in rejecting the decision in Martin Brothers, the Court of Appeal held that not just any dispute will suffice to allow a public entity to withhold retention, but that the withholding of retention funds must be based on a need for further security, such as to pay stop notice claimants or to remedy defective or incomplete work, rather than a dispute over change orders.

Notably, there was no allegation of defective or incomplete work for which the District could assert a basis to withhold retention from FTR.  The only basis asserted by the District was to withhold retention because there was a dispute as to whether FTR was owed additional monies by the District.  The Court of Appeal found this dispute did not constitute a “dispute between the public entity and original contractor,” as intended by  Section 7107.  As a result, the Court of Appeal affirmed the trial court’s award of prompt payment penalties against the District.

However, the Court of Appeal reversed the trial court’s award of attorney’s fees in the amount of $3,850,000 for violation of Section 7107.  In reversing the trial court’s decision, the Court of Appeal held that FTR would only be entitled to recovery of attorney’s fees relating solely to the cause of action for violation of Section 7107 and not all of the attorney’s fees incurred by FTR.  As a result, the Court of Appeal reversed and remanded the issue of attorney’s fees under Section 7107 back to the trial court to segregate the attorney’s fees.

B. Contractual Notice Provisions.

As a basis for denying many of the PCOs submitted by FTR, the District argued that FTR had failed to timely submit notices and change orders in compliance with the contract provisions.  The trial court held that the contractual notice provisions were forfeiture provisions and would only apply where the District demonstrated prejudice from FTR’s failure to make a timely claim.  The trial court further held that the notice provisions were unconscionable and that the prime contract was an adhesion contract.

The Court of Appeal disagreed with the trial court, stating that “[t]he problem with the trial court’s reasoning is that the contract clauses are authorized by statute.”  Specifically, the Court of Appeal correctly noted that California Government Code § 930.2 permits a public entity to include such provisions.  As a result, the Court of Appeal held that “[n]othing in the statute requires District to show prejudice” and that “the trial court erred in requiring a showing of prejudice in applying the time limitations in the article.”  Consequently, the Court of Appeal remanded the issue of FTR’s compliance with the contractual notice provisions back to the trial court to determine which, if any, of FTR’s PCO claims were timely submitted.  Thus, while it has been our experience that many arbitrators and judges have been reluctant to bar untimely claims without a showing of prejudice, the analysis of the Court of Appeal supports the position that an owner need only show a failure to timely comply in order to preclude recovery for an untimely submitted change order.  In light of the prior decision in Greg Opinksi Construction, Inc. v. City of Oakdale (2011) 199 Cal.App.4th 1107, which similarly held that an untimely submitted claim for delays by a general contractor was barred by the contractual notice provisions, general contractors should beware and ensure that timely notice is provided for all claims of extra work and delays.

Notably, this portion of the Court of Appeal decision is not published.

C. Proposed Change Orders and False Claims Action Violations.

As indicated above, the District filed a separate action against FTR contending that FTR had violated the California False Claims Act by submitting false PCOs.  Specifically, the District alleged that FTR had violated the False Claims Act on 416 separate occasions.  The trial court denied the District’s claims under the False Claims Act.

In this unpublished portion of the opinion, the Court of Appeal reaffirmed the position in Fassberg Construction Co. v. Housing Authority of City of Los Angeles (2007) 152 Cal.App.4th 720, 742, that the submission of a PCO alone does not constitute a “claim” under the False Claims Act.  In this case, the District conceded that point, but argued that a letter sent by FTR stating, “[w]e request that our (200) change orders be submitted as claims in accordance with the Contract” was a claim under the False Claims Act.  The District further argued that a PCO under which the contractor ultimately gets paid is a false claim and that the trial court awarded damages to FTR for false PCOs.

The Court of Appeal rejected the District’s position and found that the trial court did not award any damages to FTR for any portion of a PCO found to be invalid or false.  As a result, the Court of Appeal found there was no payment on a PCO that could have constituted a false claim and the trial court’s decision was affirmed.

CONCLUSION

The legal ramifications and practical lessons to be learned from this opinion touch anyone involved in public works construction in California.  This case demonstrates the significant damages and exposure of a public entity which withholds retention without sufficient justification.  It solidifies the need for a public owner to clearly identify in writing the bases and grounds by which it is withholding retention from a general contractor.  This case further demonstrates the enforceability of contractual notice provisions in construction contracts which require contractors to timely provide notice in order to perfect claims for delays and extra work.

A review of this case also demonstrates the variety of disputes that can arise on a construction project and the significant costs associated with such disputes.  The litigation costs and damages involved far outstripped the original contract amount to build the school and this decision does not end the parties’ dispute.  Lessons and best practices can be learned by both general contractors and owners alike from this decision.

 Note that the award to FTR exceeded the contract amount to construct the entire school by over $2 million.

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