In May of 2018 the California Supreme Court published a ruling which gives clarity to the application of the prompt payment statutes as applied to construction industry contracts. The case focuses specifically on the application of a builder’s right to withhold funds owing to a subcontractor when a dispute has arisen between the builder and subcontractor. The Supreme Court narrowly limits a builder’s right to withhold funds in its ruling. Basically, the only time funds can be withheld on a contract is when the dispute involves the scope of work for which the funds are related to. Although the court does not specifically reference the term “offset” in its ruling, the outcome of the ruling specifically ends the traditional use of an offset by builders in California. The following Q& A’s are useful in understanding the courts ruling.

What is a builder’s “right to offset” or “right of set-off”?

A builder’s ” the right to offset” (also known as a ” right of set-off”) is when a builder or general contractor deducts money paid to a subcontractor for one project in order to account for funds the subcontractor owed the contractor for back charges on a different project. For example, say a contractor enters into two contracts, Contract A and Contract B, with a subcontractor; the subcontractor completes the projects for Contract A with no additional expenses owed to the contractor (” back charges”), but defaults on Contract B due to back charges (for insufficient work, defective materials, etc.) that exceeded the subcontractor’s Contract B balance. Because the subcontractor exceeded its balance for Contract B, the subcontractor now owes the contractor money. However, instead of paying the subcontractor the full amount for Contract A and attempting to collect money from the subcontractor for the funds owed for Contract B, the contractor could initiate the ” right to offset.” The contractor could use the funds for the payment that would have been owed to the subcontractor for the satisfactory completion of Contract A in order to pay the expenses from the Contract B. By doing this, the contractor pays the subcontractor less for the satisfactory project, but the subcontractor no longer owes (or owes a lesser amount of) money for the unsatisfactory project.

How does United Riggers & Erectors, Inc. v. Coast Iron & Steel Co. apply to a builder’s right to offset?

The United Riggers opinion was delivered on May 14, 2018, and it interprets a section of a California statute which allows for an exception of timely payments to subcontractors. The court’s ruling limits a contractor’s ability to withhold payments from back charges only to the project on which the back charge arose. In other words, the case eliminates a builder’s right to the offset-a contractor cannot pay a subcontractor less money for one project because of expenses owed by the same subcontractor from a different project. Even though both contracts are for projects with the same subcontractor, the payments to the subcontractors for their work should be treated as if unrelated.

Can the “dispute” discussed in the case be treated as an issue distinct from a builder’s right to offset?

No, because although the case involves a “dispute” between a contractor and subcontractor regarding the withholding of progress payments, it implicates a builder’s right to offset. The case is primarily addressing the limited exceptions for which a contractor can delay payments to subcontractors. The court narrowly interprets the law which governs this issue of permissible untimely payments to be limited to disputes arising from only those withheld payments. Engaging the right to offset is an instance where a builder withholds monies from a subcontractor on one project due to back charges on another, unrelated project. It would be difficult to assert that the right of offset does not violate the court’s interpretation of the law.

How exactly does the court arrive at its opinion in such a way that it implicates the right to offset?

The court’s analysis utilizes both the interpretation of other, related laws as well as the legislative history of the statute in question.

The case primarily focuses on a dispute arising from California Civil Code section 8814 regarding the timeliness of progress and retention payments. In its analysis, the court cites California Public Contract Code section 10262.5 and California Business & Professional Code section 7108.5, which govern the ” the timing of progress payments from direct contractors to subcontractors on private and public projects.” The court asserts that these statutes explicitly limit the withholding of payments to a subcontractor to disputes over the specific payment that would otherwise be due. These laws, as well as the statute at issue, are to be ” harmonized and construed similarly.” This means that they are not to contradict one another-one law cannot allow for untimely payments should any dispute arise, while the others limit withholding to only specific disputes relevant to the monies at issue.

The opinion also emphasizes legislative history and context. The Legislature is said to have understood that a contractor or subcontractor’s ” cash flow would be impaired if any dispute between two contractors on one contract could forestall payment on another, unrelated project” when drafting the law in question. With these contextual facts, the court concludes that the statutes were meant to protect cash flow by only allowing withholding by contractors for disputes relevant to the payment that would otherwise be due.

The court opines that ” timely payment may be excused only when the payor has a good faith basis for contesting the payee’s right to receive the specific monies that are withheld.” Such a ” good faith” dispute can only inhibit funds pertaining to that particular dispute. The right to offset clearly violates the court’s narrow interpretation of California Civil Code section 8814, as the right to offset allows for builders to underpay subcontractors for a satisfactory job in order to compensate for back charges on a different contract with the same subcontractor. This would be adverse to the legislative history cited by the court because it would disrupt the subcontractor’s cash flow. The right of offset would permit withholding of monies for disputes regarding unrelated projects, which goes against the court’s interpretation of the law.

Why did the court eliminate the right to offset?

In issuing its decision, the court held that contractors can withhold money form subcontractor “only (emphasis added) when there is a dispute relevant to the specific payment that would otherwise be due.” In other words, failure to compensate a subcontractor in full for a project because the funds were used to make up for money owed by the subcontractor would go against the court’s interpretation of the law.

What should be done if any funds owed to subcontractors are currently being used to offset back charges from a different project for the same subcontractor?

If the builder’s right to offset was previously utilized and funds owed to a subcontractor are currently being used to offset back charges from a different project, it is in your best interest to go back and pay the subcontractor for the funds used to offset the back charges.

What could happen if a contractor continues to use their right to offset despite the United Riggers ruling?

Continuing to engage the right to offset despite the court’s ruling against such a practice could potentially leave a contractor vulnerable to legal action from a subcontractor that was insufficiently paid for a satisfactory project. If such a lawsuit does arise involving the right to offset, the precedent from United Riggers case would make it highly unlikely for the court to rule in contractor’s favor.

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