Progress Payment Quandaries
By: Shawn R. Farrell
Ask any lawyer, not involved in the construction industry, if a party must continue performing if it is not being paid for the services provided and the answer will be a resounding – No! You may stop working. They will tell you that non-payment is a material breach of a contract and the non-breaching party has no obligation to continue.
But this is not so simple of a question in the construction industry. Every day on construction projects throughout the country owners, architects, and engineers withhold monies from progress payments based on the unilateral and arbitrary guesses of whether the project schedule is on time; if the contractor has impacted the work of another trade; and if administrative tasks, like the execution of lien releases of sub-subcontractors and vendors, have been provided.
To answer the question for construction contracts, you need more information. Some relevant things to consider include:
- Is the contractor a prime contractor or subcontractor?
- Does the contract contain a “time is of the essence” clause or requirement to continue working despite disagreement regarding payment?
- Is the withholding of monies related to base contract work or change order work?
- What is the level of completion of the project, meaning, has the work project achieved substantial completion?
- Did the contractor provide a performance bond on the project?
- What part of the country is the work being performed and how does that jurisdiction deal with this legal issue?
When the owner withholds all or some of the money earned in a progress payment, the owner is taking a big risk. If the owner does not have the right to withhold the money, the owner has materially breached the contract with the contractor. Under the correct factual circumstances, this means the contractor is no longer obligated to complete the work for the original contract price. That is to say, cost overruns to complete are born by the owner, for the failure to pay the full amount of the progress payments to the contractor. Under this paradigm, the contractor has significant negotiating leverage over the owner, to close out a troubled project without any economic loss.
Recognizing if the contractor has such negotiating power is an important tool to protecting the company. We as an industry must do a better job analyzing these risks.
A Recent Case
A recent case of mine serves as an example of an improper withholding by an owner and a lesson learned for all of us. My client acted as the mechanical contractor on a multi-prime public works project, for the construction of a new school (the “Client”).
The relevant facts: the original contract price equaled $4.1 million; the Client obtained a performance and payment bond; as it concerned a school, time was of the essence; and the Client submitted 21 payment applications. The owner started withholding payment with payment application No. 11. The owner made a rudimentary assessment of a deficiency list and withheld $540,000. The question posed by the Client: can I walk off and if not, what do I have to do?
We considered all six of the above questions when deciding if the owner’s withholding acted as a material breach of contract. As of payment application No. 11, we knew the Client was faced determining if it should stop working or incur the financial burden of carrying the $540,000 withholding until project completion and maybe through trial. The first, and most important consideration of the assessment, would the surety (that stands in the shoes of the Client) agree that the withholding was a material breach. If the surety would not agree, stopping work would mean facing a claim from the owner for the cost of completing and a lawsuit with the Client’s surety. This path would be untenable for the Client.
The project was in Maryland and the law is favorable for the Client, meaning there must be a breach of contract in order for the owner to make withholdings from payment.
Jurisdictions following the Restatement (2nd) of Contracts or some states that have prompt payment acts, allowing for only suspension of work but not termination of work for non-payment, could produce a different conclusion. Meaning, under state law that allows only for suspension of work (an absent contract language to the contrary) a contractor that properly walks off a project because of non-payment may have to return if it is ultimately paid.
While the contractor is entitled to remobilization costs, leaving a job and being forced to return does not make for a harmonious or profitable project. Faced with these considerations, general counsel for the Client, the surety and I discussed all these legal issues, with the surety ultimately requesting the Client to proceed with the work. So, the Client kept working despite the withholding.
That said, this did not mean the Client lost its negotiating leverage for the owner’s breach. During performance, we were able to limit the withholdings to $540,000 and demand the payment of subsequent progress pay applications (the owner paying applications 16R through 21). Further, the Client continued to work, but only to the point of substantial completion. At substantial completion, the Client stopped work and the owner was forced to hire a replacement contractor to finish the work, for the cost of $200,000.
Finally, at substantial completion the Client presented the owner with an acceleration claim of $500,000. Whether the Client was entitled to the full contract balance plus acceleration costs rested on whether the owner was in continual breach of contract, since the denial of pay applications (applications 11 through 16).
If the owner did not breach, then the payment to the replacement contractor of $200,000 would be a proper set off against the $540,000, even with the Client reaching substantial completion. Further, if the owner did not breach the contract, the Client would most likely be subject to the lump sum price and not entitled to acceleration costs of $500,000. Conversely, if the owner breached since pay application no. 11, it owed the full contract balance and acceleration costs, or the payment of approximately $1 million dollars.
Fortunately, without the need for trial, we were able to persuade the owner that the withholding of pay applications 11 through 16 constituted a breach of contract. In order to prove a “material breach”, the Client demonstrated that at the time the owner withheld the money, it had no sustainable loss and, therefore, it had no reason to take the money.
No Sustainable Loss
We showed the owner had no sustainable loss in two ways. First, as this was a public project, there was a performance bond, which guaranteed completion of the project for any breach by the Client. Thus, the owner had not risk of loss. Second, the owner took out of each payment application 10% as retainage. Historically, retainage represents the amount of money necessary to finish the project if the contractor falls into bankruptcy or for other reasons can’t finish.
This meant the owner had two separate and equal means of completing the project. Without a proper basis to withhold money, the Client was entitled to the full contract balance and could seek money beyond the contract price for acceleration costs. Because we were able to demonstrate the owner’s material breach, the Client received a payment of $900,000 (which included the full contract balance without any set off).
This result could not have been possible if the Client did not appreciate that the owner does not get to withhold payments without risk, even on a public project. This type of risk analysis is very factually intensive, but necessary. A final note, a contractor is well advised to address the issue of withholding within the contract itself, as to remove the subjectivity of courts and lawyers from the equation.
