Can public entities in California retain funds during a contract dispute?

In April, the California Court of Appeals held that a public entity can only withhold funds to contractors where mechanic’s liens exist or there is a good faith dispute over performance — a dispute over the contract price is not enough.

A recent decision by the California Court of Appeals held that a school district could not withhold funds from a contractor over an alleged contract dispute. The decision, issued on April 1, 2015 in East West Bank v. Rio School District, awarded the contractor the amount of the retained money plus penalties, while breaking from a previous California appellate court decision.

The case arose when a school district retained $676,436.49 over the course of the project. When the project was completed, the school and the general contractor began a decades-long legal dispute. The ultimate result was a judgment for the contractor against the school district for over $9 million. During the legal battle, the district refused to pay any of the $676,436.49 retained.

When public entities can withhold funds

Under California state law, retention money must be paid within 60 days after a project is completed unless there is a good faith dispute between the public entity and the contractor (or general contractor and subcontractor). At issue in this case was whether any good faith dispute could legally entitle the school to retain funds, or whether under California law the dispute must be about mechanic's liens or work performance.

In its decision, the court wrote that the purpose of California law "is to deter public entities from improperly withholding retention payments . . . There is no reason to allow a public entity to retain the funds once their purpose of providing security against mechanic's liens and deficiencies in the contractor's performance has been served."

As such, the court held, the contractor was entitled to the full amount, plus the statutory penalty, which is 2 percent interest and attorney's fees.

What this decision means for contractors and public entities

Because California Appellate Courts are split on the issue, contractors and public entities must be careful when retaining funds over disputes. If it is over performance, then the funds may be withheld without penalty. A dispute over contract terms, however, may result in significant penalties under California law.

If you have any questions regarding California law on the retention of funds by public entities, contact the experienced construction contract attorneys at Law Offices of John R. Lobherr, Inc., by calling 949-751-6389.

Keywords: contract dispute, mechanic's liens, dispute over performance, California public entity, retained funds.