New Construction Law Intended to Protect Contractors Increases Costs to Owners, Commercial Lender, 1st Quarter 2003

March 2003

Effective January 1, 2002, California Civil Code Section 3110.5 requires certain owners of real estate to provide security to contractors to protect the contractors if the owners default in making payments required under their construction contracts.  Those owners who must comply, must provide, upon 10 days request by the contractor (which demand may be made at any time before or during the project), with evidence of security for payment which may take the form of one of the following three options: (1) a payment bond, (2) a letter of credit, or (3) a construction security escrow account.  Failure to provide such security permits the contractor to stop working on the project until such security is provided.  Further, owners must provide contractors with a certified copy of a recorded construction deed of trust where there is a construction loan on the property.  The requirements of this law may not be waived as such waiver is against public policy.

Legislative Background

The construction industry, led by the Construction Employers’ Association, supported this law in order to undue a recent result of a California Supreme Court ruling which held that “pay-if- paid” provisions in construction agreements are void and unenforceable because they violate public policy which underlies the statutory anti-waiver provisions of the mechanics’ lien laws.  Wm R. Clarke Corp. v. Safeco Ins. Co. (1997) 15 Cal.4th 882.  After Safeco, contractors had to pay subcontractors even if they were not paid by the owners.

Despite the ruling in Safeco, contractors still had, and continue to have, various other mechanisms by which to protect themselves against a defaulting owner.  For example, contractors could record a mechanics’ lien against the property, and/or issue a stop work order notice (“Stop Notice”) to the owner (or construction lender, where applicable).  If a contractor prevailed on its mechanics’ lien, the contractor could force a foreclosure sale of the property and recover proceeds from such sale to pay any outstanding amount due to the contractor.  If the contractor issues a Stop Notice, then the contractor may stop working on the project if the contractor is still not paid within ten days after the Stop Notice, provided there is no dispute over the work.  In the case of construction lenders, the lender may, and in some cases, must (if the contractor issues a Bonded Stop Notice) withhold payments to the owner in the amount of the Stop Notice claim.

The problem, argued the contractors, was that the mechanics’ lien and Stop Notice processes could last several years before resolution when there were disputes (as there often are in such circumstances) and tie up significant resources of the contractors (e.g., attorneys’ fees).  Moreover, as noted above, the contractors had to pay their subcontractors for the work completed while waiting to resolve the dispute with the owner.  Based on these concerns, the construction industry achieved perhaps a Pyrrhic victory, in pushing through this chimerical new law.

The problem with this new law is that owners may find themselves attempting a Sisphean task in trying to satisfy its requirements which will increase costs to owners and will inevitably reduce profit margins for contractors.

Owners Subject to New Law

There are two categories of “owners” who must comply with this new law.  First, an owner of a fee simple absolute interest in real estate, or a tenant of at least one parcel of land who is leasing the land for 35 years or more (collectively, “Owner”).  Second, the holder of a lesser interest than a fee simple absolute interest in real estate (e.g., a tenant who leases for a term less than 35 years) (“Tenant”).

An Owner must comply if such Owner enters into a contract for an amount of $5,000,000.00 or more.  A Tenant must comply if such Tenant enters into a contract for an amount of $1,000,000.00 or more.  If the contract does not specify a fixed fee (i.e., the contract is a Costs-Plus a Fee contract vs. a Stipulated Sum contract), then the threshold amount is based on the Guaranteed Maximum Price (“GMAX”) of the contract.  If there is no GMAX in the contract, then the amount is based on the parties’ good-faith estimate.

Amount of Security

The amount of the security required is based on the anticipated duration of the project.  If the project will take less than six months to complete, then the owner must put up 25% of the total cost of the work as security.  If it will take longer, then the owner must put up 15%.

Form of Security

There are three forms of security that may be provided to satisfy this law.

Payment Bond.  In order to provide a payment bond, an owner must jump through many hoops to satisfy this option.  First, the cost can be expensive (about 1.5-2% of the payment bond amount).  Second, bond companies may require the owner to put up 1.5 times the security amount as collateral for payment of the bond.  Third, bond companies usually require that a bond be issued prior to the commencement of construction.  Therefore, unless the owner obtained the bond before the work started, the owner may find himself having to pay an extra premium for the bond.  Perhaps the biggest problem with a payment bond, however, arises when there is a construction loan on the property.  Under current law, if a contractor is paid pursuant to a payment bond, the bond gains priority over any prior recorded deed of trust.  Therefore, a construction lender’s secured interest in the property may be relegated to a position behind the payment bond company.  Lenders usually frown on this.  Thus, many construction loan agreements or deeds of trust will often prohibit the owner from obtaining a payment bond.

Letter of Credit.  Costs for letters of credit can be equally expensive.  Further, in order to obtain a letter of credit, lenders will typically require security from the owner for the amount of the letter of credit, or in cases where the owner has a revolving line of credit with a lender, the lender will reduce the owner’s availability of such funds.  Compared to the other two options, this form of security will often be easier to satisfy.

Construction Security Escrow Account.  Similar to the payment bond, this option will be difficult to satisfy.  The owner will have to deposit the money with an escrow account as well as pay for the costs of creating and maintaining the escrow account.  Unlike the other two options, this law requires that the escrow be set up before commencement of construction.  Further, as is the case with a payment bond, the greatest difficulty in satisfying this requirement may arises when there is a construction loan.  The law provides that the contractor must have a perfected first priority security interest in the escrow account.  Properly drafted deeds of trust, however will require that the lender have a first priority in all accounts related to the property.  Therefore, to satisfy this requirement, the owner will need to obtain a subordination from the lender of its interest in the escrow account.  Yet another problem, assuming the contractor is able to obtain a first priority security interest in the escrow account, is that the statute allows the contractor to demand evidence of this fact.  One example of a way to establish such evidence per this law is an opinion letter from the owner’s counsel.  Again, more costs to the owner.  But, even more troubling, law firms generally will not issue opinions about priorities in security interests as opposed to issuing opinions on whether or not a security interest exists.

Exempt Parties

This law does not apply to the following: (1) Residential construction, (2) Public Works projects, (3) Housing projects in density areas such as low-income housing, (4) Publicly traded companies, and (5) Qualified private companies with $50,000,000.00 net worth.  The legislative history of this bill explains that the Legislature felt that the risk of owner default for categories 1, 4, and 5 was low and did not warrant application of this law’s security requirements.  Perhaps more interesting, the history reveals that the Legislature exempted category 3 because it did not want to increase the cost for low-income housing, indirectly acknowledging that this new law will result in increased costs to the owners.

Conclusion

This new law, which attempts to protect contractors, will result in increasing costs of construction.  In some cases, an owner may find itself in a position of not being able to satisfy these requirements.  In those cases, in order to get the job, contractors may end up having to trim profit margins to meet the aggregate cost ceiling.  In either instance, reasonable minds can differ on whether the new legislation truly helps the construction industry.