FTR v. Rio: Penalties Assessed Against School District for Withholding Contractor Funds

By Timothy L. Pierce and Benjamin Kussman,  K&L Gates, Los Angeles

In East West Bank v. Rio School District, 235 Cal. App. 4th 742 (2015), the California Court of Appeals upheld a trial court’s assessment of $1,537,404.96 in statutory penalties against the Rio School District (the “District”) for the District’s failure to timely release contractor funds pursuant to Public Contract Code Section 7107.  The Court concluded, in what constitutes a departure from another recent Court of Appeals ruling interpreting the same statutory provision[1], that Section 7101 does not allow a public entity to withhold contractor retainage on the basis of a dispute over the cost of contract work.

Under Public Contract Code Section 7107, a public entity is entitled to withhold retention funds otherwise due a contractor if: (1) there are unreleased stop-notices; or (2) there is a dispute concerning whether the work was properly performed.  In the event that retention payments are improperly withheld, “the public entity or original contractor withholding the unpaid amounts shall be subject to a charge of 2 percent per month on the improperly withheld amount…” See Public Contract Code Section 7107 (f).

FTR International, Inc. (“FTR”) was awarded a contract in the amount of $7.345 million to construct a school for the Rio School District (the “District”).  Pursuant to the terms of the construction contract, the District withheld 10% of each progress payment as retention, to be released to the contractor upon successful completion of the project.  By September 28, 2004, the District had filed a notice of completion on the project and all subcontractor stop-notices had been released.  Yet, the District still refused to release the $676,436.49 in retention to FTR.  FTR brought filed suit for breach of contract and statutory penalties under Section 7107 (amongst other claims) against the District.

In support of its refusal to release the contract retention, the District specifically pointed to Section 7107, subdivision (c):

“Within 60 days after the date of completion of the work of improvement, the retention withheld by the public entity shall be released.  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 percent of the disputed amount.” (emphasis added)

According to the District, this provision allowed the District to withhold the retention in the event of any dispute with FTR – even those disputes wholly unrelated to the purposes underlying Section 7107, namely security for the public entity in the event of subcontractor stop-notices and/or incomplete contract performance.

Throughout the course of the project, FTR submitted over 150 proposed change orders, many of which were the subject of disputes between FTR and the District.  A dispute over these change orders, the District argued, constituted a “dispute between the public entity and the original contractor” under Section 7107 that allowed the District to withhold the $676,436.49 from FTR.

Ultimately, the Court disagreed with the District’s interpretation of Section 7101 and, in doing so, expressly rejected the holding in Martin Bros. Constr. v. Thompson Pacific Constr., 179 Cal.App.4th 1401 (2009) (“We decline to follow Martin Brothers…”).  The purpose of the statute, the Court stated, was to specifically provide security to the public entity against subcontractor stop-notices and incomplete work – not to allow a public entity to withhold retention based on any dispute with the contractor. Id. (“Section 7107’s purpose of ensuring the prompt release of retention funds would not be served if any dispute justified retaining the funds.”)  Given that underlying public policy rationale, “[t]here is no reason to allow a public entity to retain the funds once their purpose of providing security against mechanics liens[2] and deficiencies in the contractor’s performance has been served.  Unless the dispute relates to one of those purposes, the public entity will not be protected from the statutory penalty.” Id.

In light of the Court’s holding, the scope of a public entity’s ability to withhold retention  has been significantly narrowed.  Under Section 7107, statutory penalties for failing to timely release retention will apply unless: (1) there are unreleased stop-notices; or (2) there is a dispute as to whether the work was completed.  Disputes as to how much a contractor is owed for completed work is not, after East West Bank v. Rio, a proper basis for withholding retention.

[1] In Martin Bros. Constr. v. Thompson Pacific Constr., 179 Cal.App. 4th 1401 (2009), the Court of Appeals held that a subcontractor was not entitled to the 2% statutory penalty because the general contractor alleged there was a good-faith dispute with the subcontractor concerning unpaid change orders.

[2] Here, the Court is likely referring to stop-notices as opposed to mechanic’s liens.  On public projects, a subcontractor cannot file a mechanic’s lien on the property.