SC Lawyer, September 2012, #2. You Can't Rob Peter to Pay Paul.

• Author: By Joshua D. Spencer

South Carolina BAR Journal

2012.

SC Lawyer, September 2012, #2.

You Can't Rob Peter to Pay Paul

South Carolina LawyerSeptember 2012You Can't Rob Peter to Pay Paul South Carolina's Statutory Payment Protections in Construction ProjectsBy Joshua D. SpencerAt its essence, the story is familiar. Woody Cash is an inexperienced developer who acquired land to build a 24-unit luxury condominium project at Lake Jocassee (Project).

Cash obtained construction financing through Jocassee National Bank (JNB) and hired Topflight Construction from Asheville to build the Project. Topflight has projects ongoing in both Carolinas on which it uses the same key subcontractors. Topflight's subcontracts with all its subcontractors contain "pay-if-paid" provisions that make payment to each subcontractor by Topflight contingent upon payment by the owner to Topflight for that subcontractor's work. The subcontracts allow Topflight to withhold payment up to 30 days after it receives payment for the subcontractor's work from the owner, even if there is no dispute over the subcontractor's work. Topflight uses one bank account to pay its subcontractors for all projects.

Cash did not consult an attorney prior to entering into the contract with Topflight. He signed a heavily modified AlA (American Institute of Architects) A101 with modified AlA A201 General Conditions, without knowing what changes Topflight made to these widely used form contracts. Cash has no idea what kind of payment arrangements Topflight has with its subcontractors. Cash convinced JNB not to require payment and performance bonds on the Project to avoid paying the required premium.

The Project, which has a 12-month schedule, went well at first. However, about four months in, subcontractors began approaching Cash during his site visits complaining Topflight had not paid them. They threatened to walk off the job and file mechanic's liens if Cash did not pay them directly. Obviously concerned, Cash approached Topflight's superintendent, Joe. Joe apologized and said that Topflight was having problems on its Hilton Head project because the owner there had refused to pay for more than two months. Despite being upside down, Topflight had continued to work and required the same of the subcontractors working on Cash's Project. Joe told Cash he thought Topflight was using Cash's money to pay for other projects.

Irate, Cash called Topflight's project manager, Pete, and demanded answers. Pete told Cash that Joe liked to exaggerate, and that the reason the subcontractors had not been paid on Cash's project was that work from each of them had failed an inspection on the Hilton Head project. Cash vociferously complained that he had been told nothing about any subcontractor's defective work on his Project or any other, and that Topflight had no right to hold his Project up even if the subcontractors were having problems elsewhere, if that was even true. Cash then went to see his Walhalla lawyer and asked whether he had any legal protection. Those protections are the subject of this article.

south Carolina's statutory -yment protections

South Carolina has several statutory provisions related to construction project payments. These statutes set up a timetable for payments; establish that performance in accordance with a contract entitles a subcontractor to payment without the condition precedent of the contractor being paid by the owner; outlaw pay-if-paid provisions; make it a criminal act to misappropriate funds paid to a contractor or subcontractor for that contractor's or subcontractor's laborers, subcontractors and suppliers; and set up a process for recovery of attorney's fees and interest related to unpaid amounts. See S.C. Code Ann. 27-1-15, et seq. (2011) (this statutory provision allows recovery of attorney's fees in some circumstances, but will not be discussed in detail in this article). These statutes are designed to prevent wrongdoing in the construction payment process, particularly by those who have received monies intended to pay for someone else's work.

Payments to contractors, subcontractors and suppliers

Pay-if-paid provisions unenforceable

In 1990, the legislature enacted S.C. Code Ann. 29-6-10, et seq. (2011)-"Payments to Contractors, Subcontractors, and Suppliers." The statute provides, "[p]erformance by a contractor or subcontractor in accordance with the provisions of his contract entitles him to payment from the party with whom he contracts." Ten years later-in 2000-the legislature enacted the "Subcontractors' and Suppliers' Payment Protection Act" (SSPPA). See S.C. Code Ann. 29-6-210, et seq. (2011).

As the SSPPA's title implies, it is intended to protect subcontractors and suppliers by ensuring they are paid when they have performed according to the terms of their subcontracts, as follows: Notwithstanding any other provision of law, performance by a construction subcontractor in accordance with the provisions of its contract entitles the subcontractor to payment from the party with whom it contracts. The payment by the owner to the contractor or the payment by the contractor to another subcontractor or supplier is not, in either case, a condition precedent for payment to the construction subcontractor. Any agreement to the contrary is not enforceable.Id. (emphasis added).

Thus, if a subcontractor performs in accordance with the terms of its contract, it is entitled to payment from the party with whom it has contracted, usually the contractor. Payment by the owner to the contractor, or payment by the contractor to another subcontractor or supplier, is not, in either case, a condition precedent to payment of the subcontractor. Payment to the subcontractor by the contractor is not conditioned upon payment to the contractor from the owner. Importantly, the parties cannot con tract around this. Therefore, pay-if-paid provisions are illegal in South Carolina construction projects.

Thus, the pay-if-paid provisions of the Topflight subcontracts are unenforceable as against public poli cy, and any attempt by Topflight to justify subcontractor non-payment based upon non-payment by the Hilton Head project owner to Topflight is illegal.

Statutory timetables for payments

South Carolina has a required timetable for payments, which applies to both public and private construction projects. See S.C. Code Ann. 29-6-10(4) (2011), Sloan Constr. Co. v. Southco Grassing, Inc., 377 S.C. 108, 659 S.E.2d 158 (2008).

"When a contractor or a subcontractor has performed in accordance with the provisions of his contract, the owner shall pay the contractor within twenty-one days of receipt by the owner of any pay request based upon work completed or service provided under the contract." S.C. Code Ann. 29-6-30 (2011). The owner must make the payment "by mailing via first class mail or delivering the undisputed amount of any pay request." Id. Once the contractor is paid by the owner, the contractor is required to pay his subcontractors within seven days. Id. Those subcontractors then have seven more days to pay their subcontractors. Id.

The chart in Figure A summarizes the statutory payment timeline requirements. The owner appears to be allowed 21 days from the date of submission of the contractor's payment application because of the realities of verifying that work is in place and obtaining draws from a construction lender. For example, once the contractor's payment application is received, it will need to be processed by the owner to ensure that it is accurate, particularly with regard to the percentage of work complete. On projects where an architect or engineer administers the contract, that design professional will need to review the contractor's work and certify the payment application. Additionally, if there is a construction lender, that lender will often have its own independent project inspector verify the percentage of work complete. All this takes time, and it may be the reason the legislature allowed a longer period of time for payment from the owner. The contractor and its subcontractors are only given seven days to make payment, perhaps because they should have already verified the amount of work their subcontractors performed when that work was included in their respective payment applications.

The payment timetable does not lessen the impact of section 29-6-20's requirement that "[p]erfor-mance by a contractor or subcontractor in accordance with the provisions of his contract entitles him to payment from the party with whom he contracts." Even if the owner does not pay the contractor, the contractor is still obligated to pay its subcontractors for work properly performed. In fact, sections 29-6-30 and 29-6-230 require it.

Section 29-6-40 provides, "[n]othing in this chapter requires that payments due a contractor from an owner be paid any more frequently than as set forth in the construction documents, nor shall anything in this chapter affect the terms of any agreement between the owner and any lender." This provision, like much of the chapter, has not received any judicial interpretation. However, it appears to take into account the fact that, on most projects, payment applications are submitted monthly and prevents a contractor from claiming the statute requires payment of applications submitted more frequently than allowed by the contract.

While the chapter allows private parties to contract around the timing requirements, it is not something that can be done surreptitiously. The statute provides, "[n]othing in this chapter shall prohibit owners, contractors, and subcontractors, on private construction projects only,from agreeing by contract to. . . payment periods different from those stipulated in this section, and in this event, these contractual provisions shall control." Id. However, in order for the waiver to be effective, the section must be "specifically waived, by section number, in conspicuous boldfaced or underlined type." See S.C. Code Ann. 29-6-50 (2011) (emphasis added). If the statutory provisions are not strictly followed, the waiver is ineffective.

The latter part of section 29-640, which is aimed at lenders, appears to be a legislative attempt to make it clear lenders are not forced to approve draw requests sooner than their loan documents require.

Cash and his attorney should carefully examine the construction contract and subcontracts to determine if Topflight made any modifications to the payment schedules in compliance with the statute. Assuming none, and that the stories Cash was told are true, it would appear Topflight broke the law if it had no other justification for withholding payment from its subcontractors.

Justifications for withholding payment

As inferred from the above-cited statutes, the contractor or subcontractors must perform their work in accordance with the terms of their contracts to be entitled to payment. See S.C. Code Ann. 29-6-40 (2011). Thus, it is possible that Topflight could have a valid reason for withholding payment from a subcontractor. However, as discussed below, the owner cannot be kept in the dark about such withholdings.

Exemptions from application of S.C. Code Ann. 29-6-10 through 29-6-50 (2011) and ambiguity of exemptions from SSPPA

Sections 29-6-10 through 29-650 do not apply to:

(1) residential homebuilders; (2) improvements to real property intended for residential purposes that consist of 16 or fewer residential units; or (3) private persons or entities owning improvements to real property when the specific improvements are not financed by a non-owner.

The import of section 29-6-60 is that the provisions of sections 29-610 through 29-6-50 apply largely only to governmental, commercial and larger-scale residential construction projects involving 17 or more units. Subsection (3) also exempts "private persons or entities owning improvements to the real property," but only when the specific improvements are not financed by a non-owner (e.g. a bank). S.C. Code Ann. 29-6-60 (2011).

When the legislature enacted the SSPPA in 2000, it was as a part of the same "chapter" as the "Payments to Contractors, Subcontractors, and Suppliers" Act, which includes the exemptions provision at section 29-6-60. As such, a strict reading of the statute indicates that the exemptions of section 29-660 apply to the SSPPA. The legislature did not resolve the issue one way or the other and did not modify section 29-6-60 in 2000. The issue of whether the exemptions of section 29-6-60 apply to the SSPPA has not been judicially resolved.

The exemptions are not an issue for the Jocassee Project because it is a residential project involving more than 16 units financed by a non-owner bank.

Liens of laborers and others on contract price

Entitlement to payment from monies received

Section 29-7-10 requires that contractors and subcontractors pay their laborers, subcontractors and materialmen for their lawful services and material furnished out of money received from the owner for their work. See S.C. Code Ann. 297-10 (2011). The section goes on to provide that such laborers, subcontractors and materialmen "shall have a first lien on the money received by such contractor for the erection, alteration, or repair of such building in proportion to the amount of their respective claims." In essence, it is a de facto trust fund statute. The statute does not "make the owner of the building responsible in any way" and "contractor[s] or subcontractor[s] [are not prevented] from borrowing money on any such contract." Id.

Section 29-7-10 "and the penalty provisions immediately following in 29-7-20 clearly contemplate the case where a general contractor is paid by an owner, then withholds payment from a subcontractor." Adams v. BD, Inc., 297 S.C. 416, 421, 377 S.E.2d 315, 318 (1989). Furthermore, the statute "requires building contractors to pay subcontractors out of the money received for the work the subcontractors are employed to perform. More importantly, the section grants subcontractors a statutory first lien on the money received by the contractor." Poinsett Constr. Co. v. Fischer, 301 S.C. 343, 345, 391 S.E.2d 875, 876 (1990). However, "the statutory lien created . . . does not come into existence until the contractor has received the money." Bellsouth Tele. v. Dekalb Concrete Prods., 1995 U.S. Dist. LEXIS 11443, *7 (D.S.C. July 28, 1995).

Each of the subcontractors on the Jocassee Project would appear to have a first lien on the proceeds paid by Cash to Topflight. That lien was defeated by Topflight if it used those funds for work on other projects.

Criminal penalties associated with failure to pay laborers, subcontractors or materialmen out of monies received from the owner

The legislature established criminal penalties for a contractor's or subcontractor's failure to pay its laborers, subcontractors or material-men from monies received from the owner to pay them. "A contractor or subcontractor who, for other purposes than paying the money loaned upon such contract, transfers, invests or expends and fails to pay to a laborer, subcontractor, or materialmen out of the money received is guilty of a misdemeanor . . ." S.C. Code Ann. 29-7-20(1) (2011). Fines go up to $1,000, with imprisonment for up to six months. Id. It should be noted, however, that there is no criminal penalty associated with "commingling" construction funds in a common account of the contractor, as Topflight does for its projects. See Rothell, supra, 301 S.C. at 170, 391 S.E.2d at 229.

A person is guilty of a misdemeanor if he or she willfully and intentionally falsely certifies to any owner or lending institution, by affidavit or otherwise, that laborers, subcontractors or materialmen on a project have been paid in full. S.C. Code Ann. 29-7-20(2) (2011), The Lite House, Inc. v. The North River Ins. Co., 322 S.C. 26, 30 n.7, 471 S.E.2d 166, 169 n.7 (1996). One exception is that if all lien rights have been waived in writing by the laborers, subcontractors or materialmen.

Id. Penalties include a fine of up to $500 and/or prison of up to 60 days. Id.

Topflight could be subject to criminal prosecution if it took Cash's money intended for the subcontractors and, without adequate justification, failed to pay that money to its subcontractors.

Waiving the right to file lien

"Any agreement to waive the right to file or claim a lien for labor and materials is against public policy and is unenforceable unless payment substantially equal to the amount waived is actually made." S.C. Code Ann. 29-7-20(2) (2011). Thus, even if Topflight inserted some provision in its subcontracts waiving the subcontractors' right to file a lien on the Project, it would be unenforceable unless, in fact, payment substantially equal to the amount waived is actually paid to the subcontractors.

Payments cannot be withheld in silence

Though the chapter provides certain instances when payments to contractors and subcontractors can be withheld, they cannot be withheld in silence. See S.C. Code Ann. 29-7-20(3) (2011). Unless the parties agree otherwise, a contractor or subcontractor can set off, against the money owed to a laborer, subcontractor or materialman, any debt claimed to be owed to the contractor by them, based upon a good faith claim that those services and materials for which payment is claimed are defective. Id. However, "[i]n order to make such a set-off, a declaration and accounting thereof must be included in any certificate submitted with an application for payment [to the owner, architect, engineer and/or lending institution] and a copy thereof or a separate notarized original of the declaration must be sent by certified mail to the affected laborer, subcontractor, or materialman at the time the certificate is submitted." Id. It is not clear from the statute or any case whether a contractor can set off debts owed from a subcontractor on one project against amounts owed by the contractor to that subcontractor on another project.

No notice was given to Cash that the money he paid Topflight for subcontractor work was being withheld based upon any claim that work was defective. If such monies were not paid to the subcontractors, Topflight violated South Carolina law by failing to give Cash notice that his money was not being paid to the subcontractors.

Conclusion

South Carolina law interjects itself intimately into the payment process on construction projects. The net result is protection for owners, contractors, subcontractors, suppliers, financial institutions and perhaps others to ensure that those who perform work are paid for it without being required to take the financial risk of someone further up the chain not paying the party with whom they contracted. While this undoubtedly creates a burden for those in the middle of such transactions, it represents a legislative shift of such risks to the parties most capable of achieving payment.