Prompt Payment Penalties: CA Court of Appeal Relaxes Standard, “Good Faith Dispute” To Be Proven By Objective Evidence

FEI Enters., Inc. v. Kee Man Yoon, 194 Cal. App. 4th 790 (2011)

To encourage general contractors to make timely payments to subcontractors, California Business and Professions Code section 7108.5 requires a general contractor to pay its subcontractors within 10 days of receiving a corresponding progress payment from the project’s owner, unless the parties agree otherwise in writing.  If the general contractor fails to do so, the subcontractor may recover a payment penalty.  That penalty is fixed at 2% of the amount due per month for every month the payment is not made.

The general contractor, however, may withhold progress payments and avoid the payment penalty if there is a “good faith dispute” over the amount owed.  The question is what constitutes a “good faith dispute.”  In the recent case of FEI Enters., Inc. v. Kee Man Yoon, 194 Cal. App. 4th 790 (2011), the California Court of Appeal held that a “good faith dispute” exists “where the arguments asserted or positions taken have objective legal tenability.”  In other words, the subcontractor does not need to show what a general contractor believed in his or her own mind.  The subcontractor only needs to show objective evidence that the general contractor’s actions were unreasonable.

In FEI Enterprises, the general contractor and low voltage subcontractor disagreed as to completion, sequencing, and testing of the subcontractor’s rough-in work.  The general contractor ultimately terminated the subcontractor and hired another to finish the work.  The terminated subcontractor brought an action seeking payment and penalties pursuant to section 7108.5.  The court held that the general contractor’s actions demonstrated a reasonable basis for denying the subcontractor’s progress payment, and thus, the general contractor avoided any prompt payment penalties.

The court noted two sources of objective evidence showing a “good faith dispute.”  First, the court found that the contract terms were ambiguous and subject to more than one reasonable interpretation.  The fact that the parties litigated over their divergent understandings of the terms further supported this conclusion.  Secondly, during the course of construction, the general contractor consistently maintained its position that the work was incomplete under the contract terms, going so far as to hire a replacement subcontractor to finish the job.  This added further objective evidence that a “good faith dispute” existed, which was sufficient to allow the general contractor to avoid prompt payment penalties.

In light of FEI Enterprises, general contractors should make sure that there is a reasonable basis based on objective evidence to support withholding progress payments from subcontractors since their own subjective view of the matter may not be sufficient to avoid prompt payment penalties.