Sometimes it Depends on “Whose” Hand is in the Cookie Jar

Hand in cookie jar

In a lengthy and somewhat detailed decision, the California Court of Appeal for First District, in Pittsburg Unified School District v. S.J. Amoroso Construction Company, Inc., Case No. A138825 (December 22, 2014), held that a public entity could unilaterally withdraw retention funds during a pending legal dispute without the court first finding that the contractor had defaulted on the public works project.

Background

In 2008, general contractor S.J. Amoroso Construction Company, Inc. (“S.J. Amoroso”) entered into a construction contract with the Pittsburg Unified School District (“District”) for the reconstruction and modernization of a high school in Pittsburg, California.

Pursuant to Public Contract Code section 22300, S.J. Amoroso elected to have retention held in an escrow account in the form of securities where it would earn interest on those securities. The escrow agreement (“Escrow Agreement”) stated that the “District shall have the right to draw upon the securities and/or withdraw amounts from the Escrow Account in event of default by Contractor as determined solely by District.”

As the project proceeded, numerous disputes arose and the District later terminated and filed suit against S.J. Amoroso alleging faulty and incomplete work in 2011. On April 28, 2011, while the lawsuit was pending, the District and S.J. Amoroso entered into an “Exist and Demobilization Agreement” (“Exist agreement”) whose stated purpose was to provide for “the prompt and orderly exist and demobilization of [S.J. Amoroso] from the Project Site in lieu of any final termination or statement of default under the Contract.”

On February 1, 2013, the District sent a letter to City National Bank, the escrow agent, demanding withdrawal of $3.5 million from the escrow account. In response, S.J. Amoroso filed an ex parte application with the trial court for a temporary restraining order and order to show cause why a preliminary injunction should not be issued. The trial court denied S.J. Amoroso’s preliminary injunction.

S.J. Amoroso appealed.

The Appellate Court Decision

On appeal, the Court of Appeal explained that the purpose of retention is to protect an owner against a contractor’s default:

It is common for construction contracts to contain terms that protect an owner’s construction funds. Owners and contractors generally structure their contracts to provide for installment payments to the contractor as the work progresses, typically as the work reaches specified sages of completion. “This payment system added incentive for the contractor to complete the work and reduces the risk of nonperformance for the owner. A percentage of funds held until completion of all of the work is called retain age and is intended both to reduce the risk of nonperformance by the contractor and to assure the completion of the work in accordance with the contract terms.” If the contractor defaults on the construction contract “then the owner is entitled to use the retained funds to complete contract. In fact, this is one of the primary reasons for which the owner insists on retainage in the first place.”

The Court of Appeal further explained that on public works projects, in accordance with the Public Contracts Code section 7107, retention must be released within 60 days of completion of the project, but that up to 150% of any disputed amount may be withheld by the public entity:

A retention fund typically consists of cash that is a percentage of each progress payment, which the owner retains to be paid at the completion of the project. [Pursuant to Public Contracts Code section 7107], retention withheld from payments made by a public entity must be released to the contractor within 60 days after completion of the project. A public entity may withhold from such payment up to 150 percent of any amount that is in dispute between it and the contractor. Failure to pay retention as required by this section exposes the public entity owner to penalty interests on amounts improperly withheld and an award of attorney’s fees.

Finally, the Court of Appeal explained that under Public Contracts Code section 22300, contractors can substitute securities in lieu of cash retention or, if retention is held in an escrow account, to direct that the escrow agent invest retention funds in such securities. “This enables contractors to earn interest on retained funds, while in turn requiring contractors to offer the same option to subcontractors from whom the contractor withholds retention,” explained the Court.

Furthermore, explained the Court, Section 2300 prescribes a form of escrow agreement which provides, among other things, that the owner has “a right to draw upon the securities in the event of a default by the Contractor” and requires the escrow agent “[u]pon seven days’ written notice . . . from the owner of the default” to “immediately convert the securities to cash and distribute the case as instructed by the owner.”

Citing two previous decisions, Westamerica Bank v. City of Berkeley, 201 Cal.App.4th 598 (2011) and Greg Opinski Construction, Inc. v. City of Oakdale, 199 Cal.App4th 1107 (2011), the Court explained that under Public Contracts Code section 22300, public owners can unilaterally declare a contractor to be in default and withdraw retention funds held in escrow prior to any judicial determination of default by the contractor.

S.J. Amoroso further argued that allowing a public owner to unilaterally withdraw retention funds from an escrow account would violate Civil Code section 1670 – which provides that “[a]ny dispute arising from a construction contract with a public entity, which contract contains a provision that one party to the contract or one party’s agent or employee shall decide any disputes arising under the contract, shall be resolved by submitting the dispute to independent arbitration, if mutually agreeable, otherwise by litigation in court of competent jurisdiction” – as well as the Due Process Clause.

The Court rejected S.J. Amoroso’s argument for three reasons. First, Civil Code section 1670 only applies by its terms to “construction contract[s]” not disputes under escrow agreements. Second, construing Section 1670 in the manner suggested by S.J. Amoroso would render nugatory the provisions of Public Contracts Code section 22300. And, finally, no due process rights are violated because a contractor has no property interest over retention funds and has remedies available through litigation or arbitration together with prompt payment penalties under Public Contracts Code section 7107.

The court also rejected a number of other arguments made by S.J. Amoroso. However, one additional argument was raised that highlights the difference between progress and retention payments. S.J. Amoroso contended that retention funds in escrow accounts were in part for the benefit of subcontractors and are therefore subject to an express trust. The Court rejected that argument because it conflated progress payments with retention. Funds held as retention were not “amount[s] paid to [the Contractor,” explained the Court. Unlike progress payments, which are payments made to a contractor as work progresses, retention is money withheld from payment to a contractor to which the contractor is not entitled until successful completion of the project. Several cases, including Westamerica, reject the argument that a contractor has any right to retention funds prior to completion of a project. Accordingly, the District did not hold funds in trust for the benefit of S.J. Amoroso’s subcontractors.

Conclusion

After denying the District its costs and fees on appeal, the Court affirmed that S.J. Amoroso was not entitled to a preliminary injunction.

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