Retentions withheld on public contracts have historically been used as a mechanism to protect the public entity from disputes that may arise from its contract with a contractor, whether such disputes related to extra work or defective work.  A public entity’s ability to withhold retentions was recently limited by the California Court of Appeal in FTR International, Inc. v. Rio School District, case No. B238618. There the Court held that a dispute over the contract price does not entitle a public entity to withhold funds due a contractor where there was no issue regarding deficient work and all stop notice liens had been removed.

FTR was the contractor under a contract with the Rio School District for the construction of a school. During construction, FTR submitted approximately 150 change orders, most of which were denied by the District.  The school was occupied in May of 2001, with construction completed in June of 2001 and a notice of completion  filed on August 7, 2001.  Under the contract, the District withheld 10% of each progress payment. Thus, upon completion, the District had in its possession $676,436.49.  The last of the stop notices was paid on September 28, 2004.  Nonetheless, the District refused to pay the balance due under the contract and refused to pay nearly all of the amounts in the proposed change orders.  The District contended that the existence of the contractual dispute entitled it to continue to withhold FTR’s retention.

FTR sued the District for breach of contract and also sought statutory penalties under section 7107 of the Public Contract Code. Section 7107 provides in relevant part: “(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.” §7107(f) provides for a penalty of two percent per month on any amount improperly held, plus attorneys’ fees and costs. Both  provisions are subject to an exception in §7107(e) where there is a “a bona fide dispute between the subcontractor and original contractor.” After a 243-Day Court trial, the trial court found in favor of FTR and awarded it $9,356,124.81, which included damages for the balance due under the contract, extra work performed, delay and disruption caused by the District and statutory penalties pursuant to section 7107. The District appealed.

The District contended that the trial court erred in awarding penalties under section 7107 because there was a bona fide dispute between it and the contractor related to FTR’s request for additional compensation. In rejecting the District’s claim, the court found that the purpose of a retention is to provide security against potential mechanic’s liens and to ensure the contractor will complete the work properly and repair defective work. The retained funds must be paid to the contractor when the security is no longer required.

The Court noted that once the stop notices had been cleared, security was no longer required as there were no allegations against FTR of deficient work. The Court specifically rejected the District’s claim that FTR’s claim required it to retain the funds as security given its dispute over the extra work: “section 7107’s purpose of insuring the prompt release of retention funds would not be served if any dispute justified retaining the funds. There is no reason to allow a public entity to retain the funds once the purpose of providing security against mechanic’s liens and deficiencies in the contractor’s affirmance has been served. Unless the dispute relates to one of those purposes, the public entity will not be protected from the statutory penalty.” Because FTR’s action was for extra work, the District was not authorized to withhold payment.

The Court’s decision in FTR disagreed with Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc. (2009) 179 Cal.App.4^th 1401, which held that a dispute over the contract price did entitle the public entity to withhold funds.  While it is currently uncertain whether the District will seek Supreme Court  review of this decision, the conflict between the FTR and Martin Brothers cases increases the potential for Supreme Court review. Until that time, the Court of Appeal has made clear that if a public entity is going to withhold funds from a contractor, there are only two  legitimate purposes in doing so: (1) to satisfy stop notices or; (2)  to address deficiencies in the contractor’s work. If neither of these  is present, the public entity must now release all retention funds or risk the possibility of being held liable for the statutory penalties of 2%.