Objective, Not Subjective Standard, Determines Good Faith Disputes Under Prompt Payment Statutes

Payment DueCalifornia has several nearly identical statutes scattered across multiple code sections that require public and private owners to promptly pay progress and retention payments to their general contractors (generally 30 days for progress payments and 45 or 60 days for retention).  These statutes also require general contractors to promptly disburse those progress and retention payments to their subcontractors (generally 10 days for both progress and retention payments).  Although these statutes provide for significant penalties of up to 2% per month on unpaid amounts, they each provide a safe harbor whereby owners and general contractors are permitted to withhold up to 150% of disputed amounts in the event of a “good faith” or “bona fide” dispute over the amount owed.  But what constitutes a “good faith” or “bona fide” dispute?

The answer has gotten less clear, but in my opinion, in a good way.  Let me explain.  Prior to 2005, no court had defined what constitutes a “good faith” or “bona fide” dispute.  Then, in 2005, the California Court of Appeals for the Fourth District, in Alpha Mechanical, Heating & Air Conditioning, Inc. v. Travelers Casualty & Surety Co. of America, 133 Cal.App.4th 1319 (2005), held that a good faith dispute under two of the statutes, Business and Professions Code section 7108.5 and Civil Code section 3260, should be determined using a subjective standard, explaining that “[t]he phrase ‘good faith’ in common usage has a well-defined and generally understood meaning, being ordinarily used to describe the state of mind denoting honesty of purpose, freedom from intention of fraud, and, generally speaking, means being faithful to one’s duty or obligation” (emphasis added).

So, since 2005, this subjective standard has been the law of the land.  If an owner or general contractor honestly (wink, wink) believed that there was a good faith dispute, he could withhold up to 150% of the disputed amounts without being subject to prompt payment penalties.  The era of the subjective standard, however, may be coming to an end.  In a case decided this year, Fei Enterprises, Inc. v. Yoon, 194 Cal.App.4th 790 (April 25, 2011), the California Court of Appeals for the Second District questioned the rationale of the Fourth District, stating that the subjective standard “places an unnecessary additional burden on the plaintiff subcontractor [note: or general contractor] to prove the state of mind of the nonpaying contractor [note: or owner].”

Examining how courts have viewed “good faith” in non-prompt penalty cases, including malicious prosecution suits, wage claims, and insurance bad-faith cases, the Second District observed that in these cases “good faith” has been determined using an objective standard.  This same standard, explained the Second District, should be applied to the prompt payment statutes because it furthers the intention of the statutes to encourage owners to timely pay their general contractors and for general contractors to timely pay their subcontractors – “Certainly, a party who has no reasonable, objective justification for withholding payment under a construction contract, but ‘believes,’ by reason of delusion, ignorance, negligence of legal counsel or otherwise, that the money is not owed should not be able to avoid penalty interest on such ground.”

However, the Second District did not go so far as to say that the Fourth District’s subjective standard is never applicable.  Rather, the Second District held that “[w]hile there are some cases where a subjective standard may properly be applied to evaluate the legal consequences of a party’s actions, such application is appropriate only in a limited number of circumstances and only when it is consistent with the intention of the parties.”  Unfortunately, it is unclear from the decision what those “circumstances” might be or when it would be “consistent with the intention of the parties.”

So, there you have it, an appellate court split, with the Fourth District (which has jurisdiction over California Superior Court cases coming out of Imperial, Inyo, Riverside, San Bernadino, and San Diego counties) applying a subjective standard, and the Second District (which has jurisdiction over California Superior Court cases coming out of Los Angeles, San Luis Obispo, Santa Barbara, and Ventura counties) applying an objective standard to good faith and bona fide disputes under the prompt payment statutes.   For contractors – whether you are a general contractor or, in particular, if you are a subcontractor – the objective standard is a welcome change in judicial direction which will  help to limit the gamesmanship in the payment of progress and retention payments.

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