California civil code (Sec)3110.5: Is the cure worse than the disease?

Real Estate Issues, Summer 2002 by Cathcart, Robert J, Jackson, Bryan C

Seeking to cure perceived slow payment practices by owners, the California Legislature may have created an ineffective cure that is worse than this infrequent disease by enacting Civil Code sec 3110.5. This new statute was sponsored by the Construction Employers' Association, supported by several subcontractor associations, and passed through the Legislature without any significant opposition or notoriety. Now, a broad range of construction consumers and contractors are scrambling to understand sec 3110.5 and how it affects their projects. Essentially, sec 3110.5 will add significant costs to private projects, increase the possibility of disputes, and will probably fail in its primary goal of securing the contractor's timely payment stream from the owner. During these recessionary times, neither the contractors nor the owners should welcome the expensive burdens imposed by sec 3110.5. Adequate "traditional" protections already existed to secure payments to contractors through mechanics' liens, stop notices, prompt payment rights, bond remedies, work stoppage rights, and private contract rights, to name a few. Perhaps a better cure for slow-paying owners would be to streamline these traditional protections rather than to invent a new, and arguably ineffective, costly, and burdensome scheme.

SUMMARY OF sec 3110.5

Provide and Maintain Security: This new statute requires non-exempt owners of non-residential, private construction projects costing more than $5 million, or owners of less than a full interest in such projects costing more than $1 million, to provide and maintain a payment bond, an irrevocable letter of credit or a construction security escrow account inuring to the benefit of the original contractor. The amount of such bond, letter of credit, or escrow account must be 25 percent of the contract amount for projects scheduled to be completed within six months, and 15 percent of the contract amount for projects scheduled for six months or more. The bond, letter of credit, or escrow account is intended to secure the owner's timely payment obligations to the general contractor on the project.

Threshold Levels: Owners of a fee simple interest in the project, defined to include certain leases of 35 years or more, and owners of lesser interests, are obligated to provide the required financial security. If the owner is a fee simple owner or long-term lessee under the statute, the security is required for projects with a construction cost in excess of $5 million. If the owner holds a non-fee simple interest, such as a lease with a term less than 35 years, then the security requirement is triggered for projects costing in excess of $1 million.

Disclosure of Loan Amounts: At the time of contracting for any construction project covered by sec 3110.5, the contracting owner must supply to the original contractor a certified copy of the recorded construction mortgage or deed of trust disclosing the amount of the loan. Requiring an owner to provide loan amounts could constitute an invasion of privacy and may encourage contractors to assert claims for more money if they perceive that additional funds are available on the project.

EXEMPTIONS

Majority Ownership: Owners who are a majority owner of the original contractor are exempt from the requirement of posting the security. Perhaps this exemption will spur the formation of new joint ventures with contractors. However, owners who hope to form such joint ventures will have to have their own contractor's licenses before forming such joint ventures under current law, Cal. Bus. & Prof. Code sec 7029. Alternatively, rather than joint ventures, perhaps this statute will cause more owners to acquire subsidiary construction companies.

Qualified Publicly Traded Companies: By its terms, sec 3110.5 does not apply to those owners who pass certain financial strength tests. One exemption is for "qualified" companies whose non-subordinated debt securities are rated as "investment grade" by a nationally recognized rating agency and are publicly traded on the New York, American, or NASDAQ stock exchanges. If a qualified company's stock is downgraded below investment grade, it will no longer be exempt from sec 3110.5. Also, an owner is excluded if it is a wholly owned subsidiary of a qualified company provided the parent guarantees "the obligations of the subsidiary under the construction contract." The statute does not appear to limit the guarantee to the payment obligations of the owner.

Qualified Private Companies: Also, sec 3110.5 does not apply to "qualified private companies" with "net worths" in excess of $50,000,000. The net worth must be calculated according to "generally accepted accounting principles." The statute is silent as to how that net worth must be demonstrated, whether by letter, certificate, affidavit or declaration under penalty of perjury, unqualified or qualified opinion, or by whom.

Fairness Concerns: The financial strength exemptions seem unfair and prejudicial to smaller or mid-- size owners and lack a credible nexus to the alleged purpose of securing timely payment to the contractor from the owner. Small owners, despite excellent payment histories, will be unfairly saddled with significant additional transaction costs while bigger "qualified" owners will have the advantage of avoiding the added sec 3110.5 transaction costs, even if the qualified owners have checkered payment histories. Again, the Legislature should have left the evaluation of owner payment risks to a contractor's own due diligence rather than placing unfair and arbitrary thresholds on transactions to the disadvantage of smaller to midsize owners with excellent payment histories.