AN OVERVIEW OF THE NEW OWNER SECURITY LEGISLATION
Section 3110.5 was added to the California Civil Code effective January 1, 2002, requiring owners of certain works of improvement to provide payment security to original contractors (contractors under contract directly with the owner). The statute was enacted at the urging of the Construction Employers' Association ("CEA"), an association of unionized commercial building contractors in Northern California, in response to the 1997 decision by the California Supreme Court that invalidated "pay if paid" clauses commonly used in subcontracts prior to that case. Wm. R. Clarke Corp. v. Safeco Ins. Co. of America, 15 Cal.4th 882, 938 P.2d 372, 64 Cal.Rptr.2d 578 (1997). Section 3110.5 provides that in many, but not all situations, the owner who contracts for a work of improvement must provide security to the original contractor in one of three forms: a payment bond, a letter of credit or cash in a construction escrow account.
Security is only required if the amount of the contract exceeds certain amounts. For the owner of a fee simple absolute interest (including for the purposes of this law, certain long-term ground leases), the contract must exceed $5,000,000 for the owner to be required to furnish security. For the owner of less than a fee simple absolute interest, the contract must exceed $1,000,000 for the owner to be required to furnish security.
Certain construction projects are exempted from the security requirements: construction of single family residences (including site work for housing subdivisions), public works projects, and certain low-income housing. The security requirements also do not apply when the owner of the project is also the majority owner of the contractor. In addition, publicly traded companies listed on the New York Stock Exchange, the American Stock Exchange or the NASDAQ stock market with "investment grade" rated debt are exempt, as are the subsidiaries of these companies, if the parent guaranties the obligations of the subsidiary under the contract. Similarly, private companies with a net worth determined in accordance with generally accepted accounting principles exceeding $50,000,000 are also exempt, as well as the subsidiaries of these companies, if the parent guaranties the obligations of the subsidiary under the contract.
If the security requirement applies, the amount of the security to be provided is 25 percent of the total amount of the contract where contract provides that the work of improvement is scheduled to be substantially completed within six months following the commencement of the work, or 15 percent of the total amount of the contract in any other case where security is required. The security may be provided in one of three forms:
- A payment bond issued by a California-admitted surety that is either listed in the Treasury Department's Listing of Approved Sureties (Department Circular 570) or that has an A.M. Best rating of A or better and has an underwriting limitation greater than the value of the bond. The bond is payable upon a default by the owner in the payment of any undisputed amount that has been due and payable for more than 30 days.
- An irrevocable letter of credit from a financial institution, for the benefit of the contractor. The maturity date of the letter of credit and other terms of the letter of credit are to be determined by agreement between the owner, the contractor, and the issuer of the letter of credit, provided that the owner is required to maintain the letter of credit in effect until the owner has satisfied all of its payment obligations to the contractor.
- An escrow account, designated as a "construction security escrow account," maintained with a licensed escrow agent, a bank, a savings and loan, an insurance company (including a title insurance company) or other specified financial institutions. The construction security escrow account must be located in California. The construction security escrow account is to be established with an initial deposit in the amount of 15 or 25 percent of the contract amount, as noted above. In addition, if the construction contract provides for retainage or retention to be withheld from periodic payments to the contractor, the owner is required to deposit all amounts withheld as retainage or retention in the construction security escrow account, until the amount maintained on deposit in the construction security escrow account equals the total amount of future payments remaining to be due the contractor under the construction contract. Once the amount on deposit in the escrow equals the remaining amount due the contractor under the contract, the funds on deposit in the escrow are to be used for payment of remaining amounts payable to the contractor. A contractor is not obligated to accept a construction security escrow account as security unless the owner establishes to the reasonable satisfaction of the contractor that the owner has granted the contractor a perfected, first priority security interest in the construction security escrow account and all funds deposited therein.
The statute provides that it is against public policy to waive the security requirements (when applicable). In addition, if an owner is required to provide security under the statute, but fails to do so, the contractor may make written demand on the owner to provide the required security, and if the owner fails to do so within 10 days, the contractor may suspend work until the security is provided.