BILL ANALYSIS {u SB 471 u} Page 1 Date of Hearing: July 13, 1999 ASSEMBLY COMMITTEE ON JUDICIARY Sheila James Kuehl, Chair SB 471 (Solis) - As Amended: June 23, 1999 {u SUBJECT u} : WORKS OF IMPROVEMENT: FINANCIAL SECURITY {u KEY ISSUE u} : SHOULD A PROPERTY OWNER WHO CONTRACTS FOR A PRIVATE WORK OF IMPROVEMENT IN EXCESS OF ONE MILLION DOLLARS BE REQUIRED TO PROVIDE SECURITY FOR THE PROJECT IN ORDER TO ENSURE THAT CONTRACTORS, SUBCONTRACTORS AND OTHERS PROVIDING MATERIALS OR LABOR ON THE PROJECT ARE PAID IN THE EVENT OF A DEFAULT BY THE OWNER? {u SUMMARY u} : Requires an owner of property who contracts for a private work of improvement in an amount exceeding one million dollars to provide one of three specified forms of security for the project. Specifically, {u this bill u} : 1)Requires an owner to provide security for a work of improvement project that exceeds one million dollars by one of the following three means: a) A payment bond from a surety admitted in California in the amount of 50 percent of the contract which is payable upon default by the owner; or, b) An irrevocable letter of credit from a financial institution inuring to the benefit of the original contractor in the amount of not less than 15 percent of the total construction contract amount. The owner shall be required to maintain the letter of credit in effect until the owner has satisfied all of its payment obligations to the original contractor; or, c) A "construction security account" maintained with a financial institution located in California, in which the owner shall deposit funds in an amount equal to the sum of three months payment on the construction contract, provided that the owner has granted the original contractor a perfected, first priority security interest in the construction security account and all the funds in it and the proceeds from it. Withdrawals from the construction security account shall require the signature of at least {u SB 471 u} Page 2 one representative of the owner and at least one representative of the original contractor. 2)Exempts from the above security requirement single-family residences, public works projects, and housing developments eligible for a density bonus (under Government Code section 65915). 3)Requires that if the security is in the form of a construction loan, the owner shall supply to the original contractor a copy of the recorded construction mortgage or deed of trust that shall disclose the amount of the construction loan. 4)Provides that the financial institution with which a construction security account is maintained shall have no duty to determine whether or how funds should be disbursed by the owner and original contractor. 5)Provides that the bill's requirement for the posting of security should not be interpreted as affecting any provision providing for mechanics' liens, stop notices, bond remedies, or prompt payment rights of a subcontractor, including the original contractor's payment responsibilities. {u EXISTING LAW u} : 1)Regulates, generally, the enforcement of mechanics' liens and the use of stop notices for private works of improvement and public works projects. (Civil Code section 3109 {u et u} {u seq u} . All further statutory references are to this Code unless otherwise noted.) 2)Requires, except as otherwise agreed to in writing, the owner of a work of improvement to pay the contractor, within 30 days following receipt of a demand for payment in accordance with the contract, any progress payment due thereunder as to which there is no good faith dispute between the parties. It also entitles a contractor to a penalty if any amount is wrongfully withheld in violation of this provision. (Section 3260.1.) 3)Provides that a general contractor who has not been paid within 35 days from the date payment is due under a written contract may serve a 10-day stop work order notice on the owner of the work of improvement. It also provides that where there is no dispute as to the satisfactory performance of its {u SB 471 u} Page 3 work, the general contractor then can stop work on the project 10 days later if the owner has still failed to make payment, and that the general contractor is insulated from any liability for delays or damages the owner may suffer as a result of the work stoppage. (Section 3260.2.) 4)Requires a general contractor, unless a bona fide dispute exists, to pay each of its subcontractors within 10 days of receipt of each progress payment. (Section 3260(d).) 5)Provides that "pay-if-paid" clauses in contracts for public and private works of improvement which provide that the subcontractor will be paid the amount specified in the contract only if the contractor is paid are void and unenforceable because they violate the public policy that underlies the statutory anti-waiver provisions of the mechanic's lien laws. ( {u Wm. R. Clarke Corp. v. Safeco Ins. Co. u} (1997) 15 Cal.4th 882 (private works); {u Capitol Steel Fabricators, Inc. v. Mega Construction Co, Inc. u} (1997) 58 Cal.App.4th 1049 (public works).) {u FISCAL EFFECT u} : Unknown {u COMMENTS u} : According to the sponsors, if an owner of a construction project defaults on its contractual obligation to a contractor, the contractor's only recourse against the owner is to file a lien against the property and/or seek compensation through the legal system. Unfortunately, supporters assert, this process can take several years and harms not only contractors, but also subcontractors, construction workers, and suppliers by tying up resources. In the meantime, following the {u Safecou} decision (summarized below), the general contractor must pay all subcontractors for work performed, regardless of whether he or she has (or can) recover against the defaulting owner. The {u Safeco u} decision, according to supporters, makes the general contractor the guarantor of the project, instead of the property owner(s) or their financiers. The supporters of the bill assert that this simply pits one victim against another, and states that this bill puts the responsibility of providing the cure upon the party who caused the harm, the property owner who breaches their contract. In addition, supporters claim existing law is insufficient to fully rectify the harm caused by an owner's default, even after passage of AB 2627 (Brown) last year, which allows an original contractor to invoke a 10-Day {u SB 471 u} Page 4 Stop Work Notice when an owner does not pay within the 30-day progress payment period. This is because, in many instances, a contract may be for a period of less than 30 days. These contracts may be for large renovation projects, where expenses are into the millions of dollars, yet exist for a duration not contemplated by AB 2627. SB 471 attempts to correct this situation by requiring that owners of construction projects with a contract value over one million dollars provide some sort of security up front. Supporters claim that by mandating that the owner of a construction project provide a payment bond, letter of credit, or construction security account, this measure will greatly reduce litigation expenses. This new requirement, supporters add, will also ensure that all parties on construction projects are paid in a timely manner, and that owners of construction projects are capable of meeting their contractual obligations prior to the commencement of the project. {u Background u} : In 1997, the California Supreme Court in the {u Safeco u} case (discussed below), concluded that a provision relating to payments, commonly included in most general contractors' contracts with their subcontractors, was unconstitutional. This bill was introduced in response to the {u Safeco u} decision which arguably places general contractors on the hook for all of the subcontractors' costs even when the contractor has not been paid. {u Recent Cases Find "Pay-If-Paid" Clauses Unenforceable u} . As noted above, in recent years, general contractors have begun to insert "pay-if-paid" provisions into their agreements with subcontractors. A pay-if-paid provision makes payment by the owner to the general contractor a condition precedent to the general contractor's obligation to pay the subcontractor for the work the subcontractor has performed. In other words, if the general contractor does not get paid, neither does the subcontractor. In {u Wm. R. Clarke Corp. v. Safeco Ins. Co. u} (1997) 15 Cal.4th 882, 888-897, the California Supreme Court held that a general contractor's liability to a subcontractor for work performed may not be made contingent on the owner's payment to the general contractor. The Supreme Court found that pay-if-paid provisions are contrary to public policy and unenforceable because they effect an impermissible indirect waiver or forfeiture of the subcontractors' constitutionally protected mechanic's lien rights in the event of nonpayment by {u SB 471 u} Page 5 the owner. The {u Safeco u} case involved a private works contract. In October of 1997, the Second District Court of Appeal applied the reasoning of the {u Safeco u} court and held that pay-if-paid contract provisions are also not enforceable in public works contracts. ( {u Capitol Steel Fabricators, Inc. v. Mega Construction Co, Inc. u} (1997) 58 Cal.App.4th 1049, 1058-1062.) {u Brief overview of Stop-Notice provisions u} . Current law provides for a "stop notice" which generally allows a contractor or subcontractor to stop work on a project if payment has not been received within the statutorily required time period. Under these provisions, the construction lender may withhold from the owner sufficient money to answer the claim and any claim of lien that may be recorded by the general contractor or subcontractors. The owner also has the duty upon receipt of a stop notice to withhold from the original contractor sufficient money to answer any claim of lien of subcontractors. Last year, AB 2627 (Brown) was enacted, which allows an original contractor to invoke a 10-Day Stop Work Notice when an owner does not pay within the 30-day progress payment period. The stop work notice is intended to allow the original contractor to stop the work of subcontractors to avoid additional costs. {u Brief overview of security options in bill u} . As noted above, this bill specifies that an owner must use one of three methods for providing security for a work of improvement project in excess of $1 million dollars. Each of the three security methods is described briefly below. 1) {u Payment bond from a surety in the amount of the contract which is payable upon default by the owner u} : A "payment bond" is defined as "a bond with good and sufficient sureties that is conditioned for the payment in full of the claims of all claimants and that also by its terms is made to inure to the benefit of all claimants so as to give these persons a right of action to recover upon such bond in any suit brought to foreclose the liens". (Section 3096.) In this case, the payment bond would be made out to the original contractor in the event that the owner defaults. After a payment bond is agreed to by an owner, an original contractor, or both, the surety providing the bond cannot be released or exonerated from the obligation of the bond by any change or modification in the contract, nor by any rescission of the contract, even in the {u SB 471 u} Page 6 event of fraud by someone other than the claimant. (Section 3225.) In short, the payment bond guarantees absolute protection for the original contractor over the duration of the construction project. Opponents contend that one indirect consequence of requiring a payment bond could be that the entire construction industry would see an increase in costs. For example, if the fee for a payment bond was 5% of the total amount, and the project was valued at one million dollars, it would result in an additional cost to the owner of $50,000. Although supporters note that these costs may be written off the owner's tax liability as business expenses, the funds are tied up, nevertheless. 2) {u Irrevocable letter of credit from a financial institution inuring to the benefit of the original contractor in the amount of not less than 15 percent of the total construction contract amount u} : A "letter of credit" is an engagement by a bank or other person made at the request of a customer that the issuer will honor through drafts or other demands for payment upon compliance with the conditions specified in the credit. A letter of credit may be either revocable or irrevocable. (Commercial Code section 5103(1)(a).) Similar to a payment bond, once it is established the issuer is liable even if there is a breach in the underlying commercial transaction. ( {u Banco Nacional De Credito Ejidal S.A. v. Bank of America u} (N.D. Cal. 1954.) 118 F.Supp. 308.) Financial institutions or banks providing letters of credit typically require an up-front fee for the service, as well as varying periodic fees depending on the nature and length of the agreement. As only 15 percent of the total construction contract amount must be covered, this might be the most popular option for the developers. However, the letter of credit must be in a place "until the owner has satisfied all of its payment obligations to the original contractor" which would mean that both parties must reach an agreement. If a dispute arose, the owner would still have to continue to pay fees to the issuer pending the ultimate resolution of the dispute. 3) {u Deposit account, designated as a "construction security account" u} : A "deposit account" is defined as a demand, time, savings, passbook, or like account maintained with a bank, savings and loan association, credit union or like organization. (Commercial Code section 9105(1)(e).) Under this bill, the {u SB 471 u} Page 7 deposit account would be designated as a "construction security account" which means the original contractor has a "security interest" compelling the owner to secure a debt with the original contractor. In other words, the original contractor is entitled to ownership of the funds in the event the owner defaults on the contract. This bill would require the owner to grant the original contractor a perfected, first priority security interest in the construction security account, and any withdrawals from the account would require the signatures of both the owner and the original contractor. That it is "perfected" means that the security interest cannot be defeated by insolvency or by general creditors. (Commercial Code section 9301.) {u ARGUMENTS IN SUPPORT u} : The Construction Employers' Association (CEA), sponsor of the bill, writes that SB 471 will "ensure that contractors, subcontractors, and construction workers are paid in the event of a project owner default. This measure will accomplish this goal by requiring that owners of construction projects with a value over $1 million, excluding single family residences and public works projects, provide a means of security to be used only in the case of default." CEA states that the bill was necessitated by the {u Safeco u} decision, "which mandated that contractors must pay subcontractors under the terms of their agreement even if the owner of a construction project defaults on their contractual obligations to the contractor. In the event of an owner default, this ruling will put contractors in serious financial jeopardy." CEA contends that "[t]oo often, mechanic's lien rights are insufficient to cover losses as a result of an owner default" and that "[g]overnment intervention is necessary as a result of the court's ruling." CEA also argues that the bill will not dramatically increase construction costs "because this measure provides two low-cost security options, a letter of credit or a construction security account." Finally, CEA states that this bill "was crafted to address frequent situations where owners take money designated for one project and spend it on other projects under the assumption that they will receive new revenue. This risky bookkeeping tactic leaves contractors especially vulnerable to owner default." {u ARGUMENTS IN OPPOSITION u} : The California Building Industry Association opposes the bill, stating, "California law already {u SB 471 u} Page 8 provides ample protection to ensure general contractors and subcontractors do not go uncompensated for their work or supplies through the use of mechanics' liens, stop notices and other safeguards. The protection afforded to general contractors and 'stop notice' law makes SB 471 of questionable need, particularly when one considers the bill would impose an unnecessary burden and expense on property owners without demonstrating a real need for such legislation." The Building Owners and Managers Association of California (BOMA) also opposes the bill, stating that it "is an unnecessary intrusion by the state in construction contract affairs that should otherwise be freely negotiated between two parties. Generally speaking, the provision of security instruments for the benefit of contractors is something that is agreed to by parties associated with a construction contract. SB 471 would mandate that owners provide one of three types of security whether or not the contractor or the owner felt it was necessary. Thus, even if a contractor had faith that the owner is willing to abide by the terms governing payment and therefore believes that security instruments are not needed, the owner will still have to provide such an instrument." BOMA argues that each of the specified security instruments create costs for the owner, tying up cash flow which the project owner needs to conduct his or her business. Moreover, the bill does not contain a provision that would allow contractors to waive their right to security when the contractor believes such security is unnecessary. {u Prior Legislation u} : AB 2627 (Brown), Ch. 986, Stats. of 1998, created a new mechanism by which original contractors could cut their losses when an owner defaults. AB 2627 allows an original contractor to invoke a 10-Day Stop Work Notice when an owner does not pay within the 30-day progress payment period. The stop work notice is intended to allow the original contractor to stop the work of subcontractors to avoid additional costs. AB 2280 (Papan) of 1998, which was almost identical to this bill, was vetoed. In his veto message, then Governor Wilson stated: "Contract matters such as payment terms and the use of security instruments are best left to the contracting parties. General contractors are free to negotiate terms that are similar to the provisions of this bill. Similarly, property owners should be able to {u SB 471 u} Page 9 negotiate these issues without legislative interference." {u REGISTERED SUPPORT / OPPOSITION u} : {u Support u} Construction Employers' Association (sponsor) Air Conditioning & Refrigeration Contractors Association Association of General Contractors of California Association of General Contractors of California San Diego Chapter California Association of Sheet Metal and Air Conditioning Contractors California Chapters of the National Electrical Contractors Association California Legislative Conference of the Plumbing Heating and Piping Industry California State Association of Electrical Workers California State Pipe Trades Council Engineering Contractors Association Fence Contractor's Association Flasher/Barricade Association Marin Builders' Exchange Sacramento Builders' Exchange State Building and Construction Trades Council of California Western States Council of Sheet Metal Workers Western Wall & Ceiling Contractors Association Numerous individual general contractors and subcontractors {u Opposition u} Building Owners and Managers Association of California California Building Industry Association {u Analysis Prepared by u} : Daniel Pone / JUD. / (916) 319-2334