Owner’s right to withhold retainage during dispute. FTR International, Inc. v. Rio School District. California Court of Appeals (2015), by Hugh Anderson

Summary: The contractor, FTR, constructed a school under a $7.34 million contract with the Rio School District. The contract required retainage of 10%. When the work was completed and the school opened for classes, the school district was holding $676,436 in retainage.

According to the controlling California payment statute, the project owner is required to release all retainage to the contractor within 60 days of completion, subject to two factors: (1) pending stop-notices (liens on public funds) by subcontractors, and (2) disputes between the owner and contractor. By statute the unexcused failure to release the retainage is subject to a penalty of 2% per month.

Several subcontractor stop-notices were pending when the construction was completed. The contractor resolved these payment issues with its subcontractors, resulting in withdrawals of the stop-notices. However, during construction the contractor had submitted 150 proposed change orders based on extra work, delays, and design errors. These change orders remained in dispute when the project was completed, and had a total value of over a million dollars. The dispute between the school district and contractor continued for years, culminating in a lengthy trial decided in the contractor’s favor. The trial court’s decision included a statutory penalty of over $1.5 million against the school district for wrongfully failing  to comply with the payment statute by not releasing the retainage within 60 days.

The school district appealed the imposition of the statutory penalty, citing the dispute over the contractor’s claims and the statute’s statement that:

In the event of a dispute between the public entity and the original contractor, the public entity may withhold from the final payment an amount not to exceed 150% of the disputed amount.

Decision: The appellate court agreed with the trial court’s levy of the statutory penalty for not releasing the retainage. Although the statute itself refers only to “dispute” and “disputed amount” without any qualification or elaboration, the court of appeals pointed out prior decisions in which it had been held that the purpose of the exceptions in the statute was to provide security to the owner. For example, if the owner claimed there was a construction defect that owner would need to fix, it would be unreasonable to require a release of retainage—that money might be needed for the repair. Here, there was no claim by the owner against the contractor; rather the dispute was limited to the contractor’s claims for additional compensation. As the court of appeals summed it up:

District points to nothing for which security was required.*** [The statute’s] purpose of ensuring the prompt release or retention funds would not be served if any dispute justified retaining the funds. There is no reason to allow a public entity to retain the funds once their purpose of providing security against mechanic’s liens [stop-notices] and deficiencies in contractor’s performance has been served.

Comment: In construction it is common to use control over funds as leverage in disputes. The school district perhaps assumed that by refusing to release the retainage it could force the contractor to yield or compromise on its claims for extra compensation. Although some might say that the golden rule of construction is “She who holds the gold makes the rules,” in this case it was the California legislature that had made the rules. The fundamental statutory rule was that retainage must be released promptly after completion. The trial and appellate courts applied the exception to the rule narrowly, focusing on the exception’s obvious purpose rather than its simple wording.

EJCDC’s retainage provisions in the Agreement forms (such as EJCDC® C-520 and EJCDC® C-525) encourage the reduction of retainage if the work is on track at the halfway marker. At substantial completion, EJCDC recommends the release of all retainage, with the exception of a cushion of funds needed as security for punch list tasks. The documents allow for set-offs for owner claims, but do not contain any provisions for freezing payment because of a contractor claim.