Bad News for Contractors and their Sureties

Posted by Larry A. RothsteinJun 22, 20210 Comments

This article appeared in the March 19, 2021 Los Angeles Daily Journal.

Karton v. Ari Design & Construction, Inc., (2021) 61 Cal. App. 5th 734, will affect the 300,000 licensed contractors in the state of California.  And not in a good way.  The case is bad law underpinned by bad public policy.

Karton, a homeowner and an attorney, contracted with Ari Design for a home remodel.  Wesco wrote Ari's $12,500.00 contractor's license bond.  A dispute arose and Karton sued Ari, Wesco and others.  Karton claimed Ari overbilled him $35,096.00.  Ari admitted to owing $13,000.00.

Thus, the dispute was seemingly over $22,096.00.  Wesco tendered its defense to Ari's counsel.  During trial, evidence was presented that, contrary to Ari's assertion that it had no employees (and therefore exempt from paying worker's compensation insurance), some of its employees testified at trial.   As a result, the trial court determined that Ari was unlicensed during construction because it hadn't carried worker's compensation insurance.  Finding Ari to be unlicensed, the court awarded the entire amount Karton paid to Ari -- $92,651.00 – under Bus. & Prof Code §7031(b) which provides:

(b) Except as provided in subdivision (e), a person who utilizes the services of an unlicensed contractor may bring an action in any court of competent jurisdiction in this state to recover all compensation paid to the unlicensed contractor for performance of any act or contract.

The trial court also awarded Karton $2850.00 in storage fees plus treble damages of $10,000.00 under CCP §1029.8 (for any unlicensed person who causes damage up to a limit of $10,000.00).  Section 1029.8 also allows the court to award attorney's fees and costs in its discretion.   Karton and his law firm sought $271,530.00 in attorney's fees against both Ari and Wesco.  Finding that Karton had over-litigated the matter and engaged in uncivil practices, the trial court reduced the fee request to $90,000.00.  The trial court awarded Karton all of the above damages ($195,501.00) against Ari and $12,500.00 against Wesco, ruling that there was no statutory or contractual basis to award attorney's fees against it.

Karton appealed both the amount of fees awarded and urged the court of appeal to impose the fees against Wesco as well as Ari.  The court affirmed the fee award against Ari, but reversed the trial court and awarded the same amount -- $90,000.00 – against Wesco.   (On March 12 and March 17, 2021, The Daily Journal published articles regarding the incivility portion of the opinion.)

This is truly an astonishing holding.  It is my understanding that Wesco is filing a petition for rehearing and/or a request for depublication.  The petition should be granted and/or depublication ordered.

In its opinion, the court refers to the Wesco bond as a “construction bond.”  Surety and construction lawyers understand that a construction bond is a bond underwritten for a specific public or private works project.  There are two components of construction bonds: (1) a performance bond which guarantees to the owner that the contractor (principal) will complete the project in accordance with the terms of the underlying construction contract and (2) a payment bond which guarantees that the contractor will pay its subcontractors and suppliers.  [See, e.g., Civ. Code §8602 (private works) and §9550 (public works)]  The contractor's license bond at issue in Karton is a statutory bond required of licensed contractors as a condition of licensure.  Bus. & Prof. Code §7071.6.  Unlike a construction bond, where the project owner (or direct contractor if the bond is given by a subcontractor) is the named beneficiary or obligee, the license bond is written on a form approved by and given to the registrar of contractors. It is for the benefit of certain defined classes of beneficiaries including homeowners, laborers (wages) and union trust funds (fringe benefits).  Bus. & Prof. Code §7071.5.

The failure by the court of appeal to recognize this distinction lies at the heart of why the case was wrongly decided.  Contractor's license bonds are required for every licensed contractor – no matter how large or small—in the state.  License bond sureties typically write them in exchange for a signed indemnity agreement and an annual premium of approximately  $300.00.  The bond premium is the same regardless of the size or experience of the contractor.  In this way, even the smallest contractor can afford the bond and the surety's risk (now $15,000.00) is relatively modest as well.  This encourages licensure – and therefore regulation by the license board which is designed and intended to protect the public from violations of the license law by licensed contractors.

In contrast, construction bonds are underwritten for a specific project and a specific contractor.  In doing so, the surety underwriter will ask:  How large is the project?  What is the contractor's experience on this type of project?  What is his or her work on hand?  The “three C's” – a term well understood in surety underwriting, includes an assessment of the bond principal's Capital, Capacity and Character.   Construction bonds involve a much higher level of underwriting and risk analysis by the surety and premiums are priced accordingly.  In some instances, where the contractor may be considered a higher-than-average risk, the surety may require collateral as a condition of issuing the bond.  

Like the pre-issuance underwriting process described above, the surety's claims analysis similarly relies on risk assessment.  What is the surety's exposure?  What are its principal's defenses?  Is there a prevailing party attorneys fee provision in either the bond or the bonded contract?   What is the principal's ability to satisfy its indemnity obligations to the surety?  These and many other factors enable the surety to make an informed risk assessment decision in order to satisfy its obligations to the owner or the payment bond claimant.

Prior to Karton, a surety's exposure to attorney's fees was understood to be capped by the penal sum of its bond and this was true of public works, private works and license bonds.  [See, e.g., Hartford Accident and Indemnity Co. v. Industrial Accident Comm.  (1932) 216 Cal. 40 (known as “The Hartford Rule”); Harris v. Northwestern National Ins. (1992) 6 Cal. App. 4th 1061; T & R Painting v. St. Paul Fire & Marine (1994) 23 Cal. App. 4th 738; Lawrence Tractor Co. v. Carlisle Ins. Co. (1988) 202 Cal. App. 3d 949, 956 (without a specific contractual provision, a surety cannot be liable for attorney's fees “beyond the express limits of its undertaking.”).

In reaching its decision, the court of appeal in Karton  relied primarily on Code of Civ. Proc. §1029.8 and Pierce v. Western Surety Co. (2012) 207 Cal. App. 4th 83.

CCP §1029.8 provides:

(Chapter 3 (commencing with Section 19000) of Division 8, of the Business and Professions Code, or Chapter 2 (commencing with Section 25210) or Chapter 3 (commencing with  Section 25230) of Part 3 of Division 1 of Title 4 of the Corporations Code, shall be a) Any unlicensed person who causes injury or damage to another person as a result of providing goods or performing services for which a license is required under Division 2 (commencing with Section 500) or any initiative act referred to therein, Division 3 (commencing with Section 5000), or Chapter 2 (commencing with Section 18600) or liable to the injured person for treble the amount of damages assessed in a civil action in any court having proper jurisdiction. The court may, in its discretion, award all costs and attorney's fees to the injured person if that person prevails in the action.
(b) This section shall not be construed to confer an additional cause of action or to affect or limit any other remedy, including, but not limited to, a claim for exemplary damages.
(c) The additional damages provided for in subdivision (a) shall not exceed ten thousand dollars ($10,000).

Section 1029.8 had heretofore never been applied to a license bond or any surety bond for that matter.  The clear wording of §1029.8 makes it only applicable to “unlicensed persons.”   Wesco is not an unlicensed person.  Ironically, license bonds are only required of licensed contractors.  License bonds are not given to unlicensed persons and the effect of the trial court's determination that Ari was unlicensed should have exonerated Wesco.  Code of Civ. Proc. §993.440.

Second, Wesco did not “provide goods or perform services” for Karton.

Third, §1029.8 is penal in nature, and therefore should have been strictly, not broadly, construed.  Bus. & Prof. Code §7099.7 provides: “No order for payment of a civil penalty shall be made against any bond required pursuant to sections 7071.5 to 7071.8.

Had Ari committed fraud in connection with the Karton remodel, Bus. & Prof. Code §7116 would make Wesco liable for any damage caused thereby.  Had the legislature intended to expose Wesco to liability for its principal's fraudulent conduct beyond the penal limit of its bond, it could have done so, but wisely decided not to.

The court's reliance on Pierce  (“The Pierce decision mandates victory for the Kartons against Wesco…”) is similarly  misplaced.  Pierce involved a $50,000.00 statutory motor vehicle retailer bond required for licensure of a motor vehicle dealer by the Song-Beverly Consumer Warranty Act.  Veh. Code §11700.  The Pierce court affirmed Pierce's motion awarding him attorney fees “in an amount not to exceed the remaining balance on the bond.”  207 Cal. App. 4th at 87.  Pierce is hardly precedent for the holding in Karton.

If Karton is allowed to stand, it will open the floodgates for lawsuits against license bond sureties and their bond principals.  Sureties, unwilling to risk exposure to attorney's fees far greater than the penal limit of their bonds, will simply pay the claim, however unmeritorious, in order to avoid potentially unlimited exposure to attorney's fees.  At that point, the surety will demand that the contractor indemnify it under the terms of its indemnity agreement and Civ. Code §2747.  If the contractor doesn't have $15,000.00, the surety's loss is reported to the license board and the contractor's license is suspended until he or she makes good.  This would be a terrible result for both sureties and contractors.  But certainly it would make for a bonanza for bond claimants and homeowners.  Moreover, the price of the bond premium will also skyrocket.

UPDATE:  On June 22, 2021, the California Supreme Court denied review and denied Wesco's request to depublish the opinion.  What this means for license bonds (and contract bonds) remains unclear, but appears in conflict with the Lawrence Tractor case cited above.